''#■ ^^p 



rr^A 




STUDIES IN HISTORY, ECONOMICS AND PUBLIC LAW 

' EDITED BY THE FACULTY OF POLITICAL SCIENCE OF 

COLUMBIA UNIVERSITY 

Volume XIV] [Number 2 



THE 

ECONOMIC THEOEY OF RISK AND 
INSURANCE 



BY 

ALLAN H. WILLETT, Ph.D. 




THE COLUMBIA UNIVERSITY PRESS 

THE MACMILLAN COMPANY, AGENTS 

London : P. S. King & Son 
19OI 



Columbia 'iHnlpeisit^ 
FACULTY OF POLITICAL SCIENCE 



Seth Low, LL.D., Presidenf. J. W. Burgess, LL.D., Professor of Political 
Science and Constitutional Law. Richmond Mayc-vSmith, Ph.D., Professor of Polit- 
ical Economy. Munroe Smith, J.U. i>., Piofcoaor oi comparative Jurisprudence. 
F. J. Goodnow, LL. u., Professor of Administrative Law. E. R. A. Seligman, Ph.D., 
Prule>sor of Political Economy and Finance. H. L. Osgood, Pli.D., Professor of 
History. Wm. A. Dunning, Ph.D., Professor of History. J. B. Moore, LL D., Pro- 
fessor of International Law. F. H. Giddings, LL.D., Protc.^ibor of Sociology. J. B. 
Clark, LL.D., Professor of Political Economy. J. H. Robinson, Ph.D., Professor of 
History. W. M. Sloane, L.H.D., Professor of History. A. M. Day, A.M., In- 
structor in Econ'jinics. W. Z. Ripley, Ph.D , Lecturer on AnUuopology. Wm. R. 
Shepherd, Ph.D., Lecturer on History. G. J. Bayles, Lecturer on Sociology. 
M. R. Maltbie, Ph.D., Lecturer on Administrative Law. 



COURSES OF LECTURES. 

I. HISTORY. — [A] Epochs of History ; [i] Mediaeval and Modern Hi.story to 
1648; [2] Continental European History, 1648-1899; [3] English History to the 
Reform Bill; [4] The United States to the Close of Reconstruction; [5] Transition 
Epochs in European History; [6] Great Britain during the XVIIIth and XlXth Cen 
turies; [7] History of Rome ; [10] Sources of European History and Methods of 
Study; [11] The Reformation; [12] Mediaeval Institutions and Culture ; [13] Open 
ing of the Lutheran Reformation ; [i4^Jj France under Louis XVI ; [14,^] The Age 
of Revolution, 1791-1S15; [15] Work ot Napoleon; [16] Constitutional History of 
England to 1689; [19-25] Periods of Cliurch History; [30] Transitions in Ameri 
can History; [31] Constitutional History of the United States; [32, ^^^ American 
Colonial History during the XVHth and XVIIIth Centuries ; [34] The War of 1812 ; 
^351 The United States since 1861 ; [37] Seminar in American Colonial History. 

II. ECONOMICS AND SOCIAL SCIENCE.— [A] Elements of Political Econ- 
omy; [I] Ecoiioiiiiic Ilisiory ; [3] lii.st.ir'.c.ii amj Practical Political Economy; [4] 
Science of Finance; [5] Fiscal and Industrial History of the United States; [7] 
Railroad Problems; [8] History of Economics; [9-10] Economic Theory; [li] 
Communistic and Socialistic Theories; [12J Theories of Social Reform; [14] Semi- 
nar in Political Economy and Finance; [15] Principles of Sociology; [16] Racial 
Demography; [17] Statistics and Sociology ; [18] Statistics and Economics; [19] 
Theory of Statistics; [20] Social Evolution; [21 J Progress and Democracy; [22] 
Pauperism ; [23] Crime and Penology ; [24] Civil Aspects of Ecclesiastical Organi- 
zations ; [29 1 Laboratory Work in Statistics; [30] Seminar in .Sociology. 

III. CONSTITUTIONAL AND ADMINISTRATIVE LAW.— [i] Compara- 
tive Consti'.utional Law of Europe and the United .States; [2] Governmental Organ- 
ization of Dependencies of the U. S.; [5] Seminar in Constitutional Law; [16] 
Comparative Administrative Law; [18] The Law of Taxation; [19] The Law of 
Municipal Corporations; [20] Seminar in Administrative Law; [31] Colonial Ad- 
ministration. 

IV. DIPLOMACY AND INTERNATIONAL LAW.— [6] History of European 
Diplomacy; [7] History of American Diplomacy; [8] Principles of International 
Law ; [10] Seminar in International Law. 

V. ROMAN LAW AND COMPARATIVE JURISPRUDENCE.— [21] His 
tory atid Institutes of Roman Law; [22] Roman Law; Cases from the Digest; [23J 
History of European Law ; [24] Comparative Jurisprudence : General Principles ; 
[25] Comparative Jurisprudence : Special Relations ; [25] International Private Law; 
[29] Seminar in Legal History and Comparative Legislation; [30] Private Law of 
Colonies of the U. S. 

VI. POLITICAL PHILOSOPHY,— [40] General History of Political Theories ; 
[41] History of American Political Philosophy; [42] Seminar in Political Philosophy 



The course of study covers three years, at the end of which the degree of Ph.D. 
may be taken. Any person not a candidate for a degree may attend any of the courses 
at any time by payment of a proportional fee. University fellowships of ^^650 each, 
the Schiff fellowship of ^600, the Curtis fellowship of #1200 and University schol- 
arships of g 1 50 each are awarded to applicants who give evidence of special fitness to 
pursue advanced studies. Several prizes of from $50 to ^250 are awarded annually. 
Three prize lectureships of ^^500 each for three years are open to competition of grad- 
uates. The library contains over •; 10.000 volumes, and students have access to other 
great collections in the city. 



/^ *7 



2 

THE ECONOMIC THEOET OF EISK AND 

INSURANCE 



STUDIES IN HISTORY, ECONOMICS AND PUBLIC LAW 

EDITED BY THE FACULTY OF POLITICAL SCIENCE OF 
COLUMBIA UNIVERSITY 

Volume XIV] [Number 2 



THE 

ECONOMIC THEOEY OF EISK AND 
INSURANCE 



ALLAN h! WILLETT, Ph.D. 




THE COLUMBIA UNIVERSITY PRESS 

THE MACMILLAN COMPANY, AGENTS 

London : P. S. King & Son 

19OI 



PREFACE 

The following study deals almost exclusively with the ideal- 
ized conditions of the static state. It only incidentally attempts 
to show the bearing of the static laws on the phenomena of the 
real world or the practices of existing insurance companies. 
It must consequently wear something of the air of unreality 
which attaches to all discussions that deal largely with abstrac- 
tions. Its only purpose is to shed a little light on a rather 
neglected portion of pure economic theory. 

A word of explanation may be in order with regard to my 
failure to give credit to others in all cases for ideas which have 
been published before. This has sometimes been due to the 
fact that the ideas were so much common property that it was 
impossible to assign them to any particular writer. In other 
instances the omission is to be explained on the ground that 
in the course of a considerable amount of reading on the sub- 
ject of insurance, the significance of many statements was over- 
looked at the time when they were read. After their import- 
ance had come to be appreciated, it was not always possible 
to trace them to their sources. 

It gives me pleasure to acknowledge my indebtedness to 
my friend. Professor James P. Kelley, for the valuable assist- 
ance which he has given me in preparing this book for the 
press. He kindly undertook to read it all in the proof, and I 
have been indebted to his suggestions for many improvements, 
both in substance and in form. 

Allan H. Willett. 

Columbia University, May 20, 1901. 

287] 5 



CONTENTS 



INTRODUCTION 

PAGE 

General Theory of Distribution ii 

I. The Static State 12 

Conception reached by a process of abstraction .... 13 

Risk as a disturbing factor 14 

Distinction between the ideal Static State and the approx- 
imate Static State • 16 

II. Profit and the Entrepreneur 16 

Economic character of the captain of industry 18 

Nature of profit < . . . . 18 

Distinction between profit and other monopoly gains . . 19 

The entrepreneur as the recipient of profit 20 

The capitalist-entrepreneur 23 

CHAPTER I 

THE NATURE OF RISK 

Appearance of accident due to limitations of man's knowledge 25 

Distinction between chance and uncertainty 27 

Risk related to uncertainty 28 

How degree of risk may be estimated 29 

Effect of increasing the number of risks 3^ 

Area of uncertainty 32 

CHAPTER II 

CLASSES OF RISKS 

Economic and extra-economic risks 35 

Personal risk • 3^ 

Risks to capital and risks to labor 37 

289J 7 



1/ 



8 CONTENTS [290 

PAGE 

Positive and negative loss 38 

Static and dynamic risks 38 

Developmental risks 41 

Comparison of static and dynamic losses 43 

Other classes of risks 45 

CHAPTER III 

THE COST OF RISK 

Repellent influence of uncertainty 50 

Disturbing factors 50 

Effect of inequalities of risk upon the apportionment of capital 53 

Effect of the law of diminishing utility 54 

How cost of risk may be estimated 55 

Burden rests upon consumers 56 

CHAPTER IV 

THE ASSUMPTION OF RISK 

In what sense risk-taking is productive 60 

Social gain from the assumption of risk 62 

How the amount of the reward for risk-taking is determined . 64 
Distinction between reward for risk-taking and accidental gains 

and losses 66 

Reward obtained through the insurance fund 67 

Insurance fund includes only accumulations for uncertain losses 69 

CHAPTER V 

THE REWARD FOR RISK-TAKING 

Capitalists assume risks and receive the reward 72 

Pure interest and the reward for risk-taking 74 

Interest and the insurance fund 75 

Profit and the reward for risk-taking 77 

Relation of the entrepreneur to risk 79 

Advisability of making the reward for risk-taking a separate 

category of distribution , . . . 83 



2Qi-| CONTENTS g 



PAGE 



CHAPTER VI 



WAYS OF MEETING RISK 

Avoidance, prevention and assumption 86 

On what principles the choice is made by a man in isolation ; 

by a man in society 88 

Effect of society on risk and on prevention 9° 

How far preventive measures will be adopted 93 

Social methods of meeting risk ; distribution of losses .... 95 

Corporations • 95 

Mutual guarantee against loss 9^ 

Transfer of risk 97 

The capitalist-entrepreneur as insurer 99 

CHAPTER VII 

INSURANCE 

Definition of insurance io5 

Gain from combination of risks lo? 

Other economic benefits of insurance . m 

Cost of insurance ^^^ 

Insurance as a method of distributing losses 114 

Insurance not gambling i^S 

How entrepreneurs choose between prevention and insurance 117 

Accumulations by insurance companies 119 

Productivity of the insuring capital 122 

In what sense all insurance is mutual 123 

CHAPTER VIII 

CONCLUSION 

Influence of risk on the accumulation of capital 128 

Relation ot the entrepreneur to developmental risks .... 132 

Speculation as a method of creating security ........ i34 

General summary of the static theory of risk and insurance . 139 



INTRODUCTION. 

In the present unsettled condition of economic theory and 
of economic terminology, a profitable discussion of any 
theoretical question is hardly possible without a preliminary 
declaration of faith and definition of terms. Much that I have 
to say about risk and insurance concerns matters of fact, and 
will be found equally true, or false, under any view of dis- 
tribution. But it is different with such problems of theory as 
the economic identity of the risk-taker, or the influence of 
insurance on distribution. How is it possible to determine 
the relation of the entrepreneur to risk, before an agreement 
has been reached as to the function of the entrepreneur and 
the nature of his reward? How can the place of insurance 
in economic theory be established, before it has been made 
clear what are considered to be the correct categories of dis- 
tribution? There is need of no further justification for pref- 
acing a study of a special subject like insurance with a pre- 
liminary statement of the general theory of distribution on 
which the the argument is based, than the desire to avoid 
ambiguity in the use of terms, and so to assure the meeting of 
minds which is as essential to an intelligent disagreement 
among economists as it is to a binding agreement among 
lawyers. 

The theory of distribution on which the following discus- 
sion is based, is in all essential respects the specific productivity 
theory elaborated by Professor J. B. Clark, and partially given 
out in his recent work on The Distribution of Wealth. Accord- 
ing to that theory there are two, and only two, productive fac- 
tors, labor and capital. All wealth is the product of these two 
factors. Under the influence of static forces there is a con- 
2933 " 



12 THEORY OF RISK AND INSURANCE [204 

stant tendency not only to give to each factor as a whole the 
part of the product whose creation is the result of its presence, 
but also to give to every unit of labor and to every unit of 
capital that part of the product that is specifically imputable 
to it, and to make those specific contributions and rewards to 
either agent uniform throughout the industrial system. Dy 
namic forces, on the other hand, are continually introducing 
new disturbances into the industrial system and creating new 
variations in the productivity of different units of labor and 
capital. In the world of reality both kinds of forces are in 
operation, the latter causing new discrepancies between actual 
values and normal values, and the former gradually obliterating 
them after they have been created. 

It is no part of my task to attempt a complete statement of 
the specific productivity theory of distribution, or to enter into 
a discussion of the arguments for and against it. But there 
are two points in the theory which must be touched upon in 
order to make the following discussion intelligible. It is my 
purpose to attempt to show the influence of risk and of insur- 
ance on static rates of wages and interest; and that makes 
necessary a statement of the relation of risk to the static state. 
I shall also discuss the connection between the reward for 
risk-taking and the income of the entrepreneur ; and as there 
is no phase of economic theory which is in a more unsettled 
condition than the doctrine of the entrepreneur, a preliminary 
explanation of the conception of his function on which the 
argument is based seems indispensable. 

THE STATIC STATE. 

The conception of the static state is purely ideal. Econ- 
omists have always recognized the necessity of distinguishing 
between existing values and normal or natural values, and 
have made more or less successful attempts to isolate the 
forces which contribute to the determination of the latter, and 
to study them apart from temporary and local disturbances. 



2grn INTRODUCTION 1 3 

What earlier writers did in a more or less indefinite and incom- 
plete way, Professor Clark has done definitely and completely. 
He has made a clear and precise distinction between the forces 
which are responsible for variations of existing values fi-om 
normal values, and those which are continually tending to 
bring about agreement between the two. To the latter class 
of forces he applies the term static; and the static state is one 
in which all disturbing forces have ceased to act, and actual 
values have been brought into agreement with normal or 
static values. 

The conception of the static state is reached by a process of 
abstraction. It is necessary in the first place to put aside all 
economic phenomena which occasion new variations in the 
productivity of different units of labor and capital.^ These are 
caused by dynamic changes, which may be grouped under five 
heads : changes in the quantity of labor, changes in the quan- 
tity of capital, changes in technical methods of production, 
changes in methods of industrial organization, and changes in 
human wants.^ Moreover the process of abstraction cannot 
stop here. If all dynamic changes were to cease, the ideal 
static state would never be realized in human society. There 
are other assumptions which have to be made, such as a high 
degree of mobility of capital and labor, the universal prevalence 
of the economic motive,3 and the power of accurately foreseeing 

1 Professor Clark in his classification of dynamic changes includes only such as 
are found in a progressive society. But he recognizes that a complete science of 
dynamics would have to include a discussion of the effects of changes in the 
opposite direction, a t|ieory of retrogression as well as a theory of progress. 

2 It has been suggested that changes in legal relations ought to be recognized 
as a separate group. This would include changes.iti laws affecting property 
rights, franchises, taxation, immigration, and the- like. Manifestly such changes 
have a very disturbing effect on economic relations ; but it is only in so far as they 
bring about economic changes. They are primarily social, and all the possible 
secondary changes of an economic nature are included in the classification given 
above. 

3 The relation of competition to the static state has been discussed by Mr. Padan 



14 THEORY OF RISK AND INSURANCE [296 

the future. These assumptions depart more or less from the 
actual condition of things. Labor and capital are far from 
being absolutely mobile, rates of wages and interest are not 
determined exclusively by economic considerations, and the 
result of an industrial operation does not always agree with 
the expectations of those who enter upon it. 

It is the influence of the last of these disturbing factors on 
static rates of wages and interest that we are to seek to deter- 
mine. The ideal static adjustment could be realized only on 
the condition that there were no discrepancies between the 
anticipated and the actual results of economic activity. Pro- 
duction and consumption must go on either with absolute 
uniformity or with a regular periodicity which in a series of 
years would result in uniformity. Unusually warm winters 

in a recent number of the jfournal of Political Economy (Vol. ix., no. 2, p. 182, 
et seq.). He proposes to include " circumstances of competition" as "an impor- 
tant agent of a highly dynamic character." His idea of the static state involves 
the absence of competition. According to his conception " a static state is simply 
an instantaneous photograph of a dynamic period [sic'] at any moment." Mani- 
festly such a static state " is incapable of setting a standard [of wages and inter- 
est] because it is incapable of creating one." The unequal rates of wages and 
interest brought about by the previous dynamic changes would simply be per- 
petuated. But it is very different with the static condition here described. If 
the dynamic changes above enumerated were to cease, there would be a period 
during which capital and labor would be shifting from group to group, seeking 
the most advantageous employment. After a time, however, the existing amount 
of the two agents would be so apportioned that all units of each would be equally 
productive, and there would no longer be any reason for shifting. Mr. Padan 
tries to make it appear that we have here two kinds of static state, and that in the 
former, according to Professor Clark, competition is imperfect, and in the latter 
perfect, and that perfect competition is no competition. The fact is, of course, that 
the intermediate condition is not a static state, that the static state is reached only 
when the condition of uniform productivity prevails, that such a condition would 
be permanent for lack of any incentive to change, and that competition, or the 
desire to improve one's economic condition, is assumed to be just as " perfect," 
that is, " active," in the one state as in the other. In the ideal static state its effect 
is not seen in motion because there is no advantage to be gained by movement. 
But to say for that reason that it is absent is as absurd as to say that the force of 
gravitation is not acting on the water in a pond if there is no motion of the drops. 



2Q7l INTRODUCTION 1 5 

with a reduced consumption of woolens and furs, or unusually 
dry summers with a reduced production of agricultural com- 
modities, must occur at stated intervals, if at all, so that they 
may be accurately foreseen and provided for. The unreasoning 
vagaries of fashion, which cause unexpected shiftings of value 
from one form of commodity to another, must be replaced by 
a fixed or a uniformly varying demand, whose effect on values 
can be anticipated. 

While unforeseen losses are occurring, either through the 
failure of an industrial operation to yield the physical product 
which it was expected to give, or through a variation between 
the anticipated and the actual value of the product, the ideal 
static state is not realized. Every such loss is in itself a 
dynamic change. The possibility of such chance variations 
is one of the conditions under which economic activity is car- 
ried on. It is a fact of experience to which mankind has to 
adapt itself, just as it adapts itself to the other conditions of its 
physical environment. An unexpected loss, when it occurs, 
reduces the amount of capital at some point in the industrial 
system, and the failure of an anticipated loss to appear leaves 
an abnormally large amount of capital in some part of the 
system. Every occurrence of either kind makes necessary 
more or less shifting of capital to restore the static condition. 
While uncertainty exists, then, the ideal static state can never 
be realized. Not only do the losses cause a disturbance of the 
static adjustment, but the risk of loss also has an influence on 
economic activity. In discussing the pure static theory it is 
necessary to abstract from the possibility of accidental loss, and 
to assume a degree of certainty in human affairs which does 
not actually exist. The purpose of the following discussion 
is to restore to this conception the element of risk, and to 
determine in what way the static state, as it can be realized 
while risk exists, differs from the ideal static state for whose 
realization the absence of risk must be assumed. If men 
should acquire no greater control over the forces of nature 



l6 THEORY OF RISK AND INSURANCE [298 

and no better devices for restraining the irregularities of human 
conduct, than they now possess, and if knowledge and ability 
to foresee the future should remain in their present imperfect 
condition, the static state which would develop even after the 
lapse of a long period of time could be only approximately 
perfect. Rates of wages and interest would not exactly coin- 
cide with static rates. Why they would vary under the influence 
of risk, and to what degree, are the questions which we are to 
try to answer. As a matter of convenience we shall refer to 
the perfect adjustment which would be reached in the absence 
of all disturbing forces, including risk itself, as the ideal static 
state, and to the adjustment which would be reached while 
risk continued to affect human activity, as the approximate 
static state. And we shall first endeavor to discover the effect 
of the existence of risk unmodified by the influence of any 
social device for counteracting it, and then see in what way 
and to what degree the introduction of insurance will modify 
this influence. 

PROFIT AND THE ENTREPRENEUR. 

The only phase of the theory of risk which has been dis- 
cussed to any extent has concerned the relation which it bears 
to the function and reward of the entrepreneur. Does the 
income of the entrepreneur consist in whole or in part of re- 
ward for assuming risk ? The answer to that question will 
evidently depend on the definition which is given to the term 
entrepreneur. It is necessary, then, to state clearly the sense in 
which the term is used, before attempting to pass judgment 
upon the connection of the entrepreneur with risk and the 
reward for assuming it. 

There are two ways of approaching the problem of the en- 
trepreneur. We may seek to determine what forms of activity 
he carries on, and from them infer under which of the cate- 
gories of distribution his income falls ; or we may differentiate 
the various forms of economic income, and identify the entre- 



299] INTRODUCTION 1 7 

preneur by the fact that he receives a distinct share in the dis- 
tributive process. The problem is usually approached from 
the side of activity, and not of reward. The attempt is made 
to identify the entrepreneur by considering what he does, and 
not what he receives. He is regarded as the captain who mar- 
shals and directs the productive forces of society. He brings 
together labor and capital, to cooperate in the production of 
the commodities which society needs. He strives to anticipate 
future changes in human wants, and to adapt the stream ot 
commodities to the demands of society. He is perpetually on 
the alert to devise improvements in organization or in methods 
of production which will diminish his expenses, and to adopt 
such improvements when introduced by others. It is the ac- 
tivity of entrepreneurs which is continually causing diver- 
gences between expense of production and price, and it is 
the competition of entrepreneurs which tends to annihilate 
these divergences after they have appeared, and in the end to 
assure to capitalists and laborers the entire product of their 
industry. 

Under which category of economic activity does this service 
of directing the productive forces of society fall ? On this 
question there appears the greatest diversity of opinion. To 
some the person who renders it is a laborer, performing a 
special kind of work, and his income appears as wages of 
management; to others he is a capitalist, serving society by 
carrying risk, and his reward, though called by another name, 
is a form of interest; while still others look upon him as a 
combination of laborer and capitalist, and consider his extra 
gain to be due to the advantage this dual role assures him. 

This very diversity of opinion is an indication of the com- 
plexity of the service which the captain of industry renders. He 
is undoubtedly a laborer, and it is necessary to recognize in 
his income an element of wages. Its amount would be deter- 
mined in the same way as the wages of any independent work- 
man are determined. It is that part of his income which 



1 8 THEORY OF RISK AND INSURANCE [300 

he could obtain by giving the service of his knowledge and 
ability to an employer. He may be a capitalist, and if he is, 
his income contains an element of interest, which is equal in 
amount to the return he could obtain by allowing another per- 
son to use his capital. He may be the residual claimant in 
the industry which he directs, and as such he will receive the 
profit of the industry, the residual product after allowing for 
the payment of all labor and capital employed, his own in- 
cluded. 

Now in the accepted nomenclature of economic science, the 
term entrepreneur has come to designate this director of 
industry. But it is evident that such a conception is extremely 
complex, involving more than one of the distinct forms of 
economic activity. It is consequently of little service in at- 
tempts to solve problems of distribution. The chief reason for 
dififerentiating the entrepreneur from the other productive 
agents is the desire to dispose of the element in distribution 
which is neither wages nor interest, and which is commonly 
called profit. In other words, the conception of the entre- 
preneur which will be useful in economic analysis is the one 
which is obtained by approaching the problem from the side 
of reward instead of that of activity. 

All wealth is produced by capital and labor. In an ideal 
static state the productivity of all units of capital is the same, 
and each unit receives as its share in the distributive process 
the portion of the product specifically attributable to it. The 
same thing is true of labor. Interest, the return to capital, 
and wages, the return to labor, absorb the entire net product 
of industry. But in a dynamic state this uniformity of pro- 
ductivity does not prevail. Dynamic changes are continually 
disturbing the static adjustment. An improvement in tech- 
nique, for example, introduced in a particular factory belonging 
to a special industry, reduces the expense of producing the 
commodity which the factory turns out. So long as this 
factory has a monopoly of the improvement, it may continue to 



30l] INTRODUCTION ig 

sell its output at the price fixed by the former cost of produc- 
tion. The same amount of product can be turned out with a 
smaller amount of capital and labor, or a larger amount of 
product with the same amount of capital and labor. • That is, 
the productivity of each unit of labor and capital in the group 
is increased. The excess of receipts over expenses of produc- 
tion, with market wages for labor and interest for capital 
included in the latter, is profit. Its source is usually in a 
dynamic change, resulting in a localized lowering of expense 
of production, or, what is the same thing, in a localized 
increase in the productivity of capital and labor. 

It IS clear that under free competition such a profit must 
always be transient ; it can endure only while the monopoly 
endures. As other factories adopt the same improvement, the 
supply of goods at the lower cost of production is increased, 
until finally the entire demand is supplied at the reduced cost 
and the price drops to the level which the new cost justifies. 
When that point is reached, if we disregard secondary changes 
induced by the primary one, the gain from the improved 
method of production, which at first appeared as a profit in a 
particular part of the industrial system, has become a per- 
manent net addition to the productivity of all capital and 
labor, through the fall in the price of the commodity. 

It is clear, therefore, why profit may properly be called a 
dynamic income. If all dynamic changes were to cease, un- 
equal rates of productivity of capital and labor in different 
parts of the industrial system would result in a shifting of 
capital and labor from less productive to more productive 
groups, until a uniform rate of productivity had finally been 
reached. The profit would endure only so long as the influ- 
ence of the dynamic change was felt; with the attainment of 
the perfect static adjustment it would entirely disappear. 

Profit, then, appears as a result of the abnormal productivity 
of capital and labor in some part of the industrial system. Like 
all abnormal gains, it is due to a monopoly advantage. But it 



20 THEORY OF RISK AND INSURANCE [302 

by no means follows that all monopoly gains ought to be 
classed as profit. Profit has to be distinguished from certain 
permanent monopoly gains which either capital or labor in- 
dividually may create, and which they are, therefore, able to 
retain as their own income. If certain laborers are in a posi- 
tion to prevent the free flow of labor into their industry and so 
to keep up the marginal productivity of labor in it, they may 
be at the same time in a position to force from the employers, 
in the form of higher wages, the entire excess product; and 
in the same way, if certain capitalists have a similar monopoly 
power, they can appropriate to themselves the resulting 
monopoly gain. If, however, the restriction on the flow of 
capital into the industry is due to the power of the entrepreneur 
to keep it out, as in the case of his ownership of a patent-right, 
the resulting abnormal product is an entrepreneur's profit. 
Profit is due to the increased productivity of the industry as 
a whole. Laborers as such have no claim to it, as they are 
entitled to no more than the market rate of wages; capital- 
ists as such cannot appropriate it, as their reward is determined 
by the market rate of interest. The monopoly gains of labor 
alone or of capital alone are created by the agents which re- 
ceive them ; profit is an extra product, created by capital and 
labor as the result of a localized increase of productivity, which 
neither is in a strategic position to claim for itself 

It is profit as thus defined which Professor Clark regards as 
the peculiar reward of the entrepreneur. Considered from the 
side of his income, the entrepreneur is a person who is in a posi- 
tion to appropriate the results of the extra productivity of capi- 
tal and labor. The person to whom such extra gains accrue 
in any industry is the person who has the legal right to the re- 
sidual product of the industry. Cases can be imagined in 
which they would accrue to one who had contributed neither 
capital nor labor. Such a person would be ti pure e7itrepreneur, 
and his income would be pure profit. But it is evident that 
generally speaking the residual claimant or entrepreneur is at 



- Q ,-| INTR OD UC TION 2 1 

the same time a capitalist. He owns the whole or a part of 
the capital invested in the industry, and his claim to the re- 
sidual share of the product is based on his property rights. 
Such a person combines the functions of capitalist and entre- 
preneur, and only that part of his income is profit which is in 
excess of the return he could obtain by allowing another to use 
his capital in the same way in which he is himself using it. 

Such is the conception of the function and reward of the 
entrepreneur which is obtained by considering them from the 
side of income. The residual claimant in any industry is 
the entrepreneur. Evidently it is impossible to reconcile this 
conception with the popular one described above. If the same 
term is to be employed to denote the person who is entitled to 
the residual share of the product, called profit, and the person 
who renders the complex industrial service commonly attrib- 
uted to the entrepreneur, it is necessary to show, first, that there 
are no directors of industry who are not residual claimants, 
and, second, that there are no residual claimants who are not 
directors of industry. Neither of these claims can be estab- 
lished unless we give to the term director of industry a much 
broader meaning than it has in popular usage. The owner of 
a few shares of stock in a large corporation is one of the resid- 
ual claimants, entitled to a portion of any profit which may 
appear; but common economic usage hardly justifies us in 
calling him an entrepreneur. It is true that he is legally enti- 
tled to a voice in controlling the policy of the corporation 
through his right to vote for the board of directors; but such 
imperfect and remote control as that is not the form which is 
had in mind when the director of industry is spoken of. On 
the other hand, the work of directing the productive forces of 
society is often done by men whose income is entirely in the 
form of a fixed salary. Hired managers are frequently the ones 
who inaugurate improvements in any industry or adopt im- 
provements introduced by others, and help to establish the pro- 
ductivity rate of wages and interest, which is one of the chief 



22 THEORY OF RISK AND INSURANCE [304 

results of the activity of the directors of industry. Common 
usage does not justify us in denying to such a person the title 
of entrepreneur. 

If the preceding analysis is correct, it is impossible to estab- 
lish any necessary and universal connection between the one 
who performs the function of the entrepreneur, as the term is 
ordinarily used, and the recipient of the residual product of 
industry called profit. A recognition of these facts will clear 
up many of the difficulties which have arisen from the attempt 
to use the same term to denote the two persons. Common 
custom has undoubtedly been on the side of using the word to 
denote the person performing the directive work of society. 
But, as we have already stated, in discussing questions of dis- 
tribution it is more useful to adopt a conception of the entre- 
preneur which connects him with a distinct form of income, 
than one which is based on a complex form of activity, with no 
definite significance for distribution.^ Functional distribution 
must logically precede personal ; and for the purpose of a dis- 
cussion of functional distribution terms must be defined in such 
a way that each economic agent may be connected with a dis- 
tinct form of income. The conception of the entrepreneur as 
the recipient of the normal profit must be acknowledged to be 
more precise and more serviceable than the complex concep- 
tion commonly attributed to the term. 

It is customary in economic analysis to speak of capitalists 
and laborers as though they were always separate and distinct 
persons. It is just as convenient many times to use the con- 
ception of a pure entrepreneur, a man who is neither capitalist 
nor laborer, and whose income includes neither wages nor 
interest. It is necessary to think of him as a person who has 
no capital of his own, but is able in some way to obtain capital 

1 The entrepreneur has a certain function, but it is of a passive, mercantile nature, 
not to be confounded with the active function of the captain of industry. I have 
placed a great deal of ennphasis upon the income, because it is easier to identify 
the entrepreneur by means of it than in any other way. 



305] INTRODUCTION 23 

from others by paying the market rate of interest; who per- 
forms no labor on his own part, but hires the labor of others at 
the market rate of wages; to whom the product of the indus- 
try in the first instance belongs, and whose income is pure 
profit, the net return which he can obtain for his product in 
excess of the wages and interest that he has to pay for his labor 
and capital. In the discussion which follows the term pure 
entrepreneur is always to be understood in this sense. 

The pure entrepreneur with no capital of his own would be 
at a great disadvantage in the actual world. There are few 
owners of capital who would be willing to give the use of it to 
persons with no security to offer for its safe return. The more 
common form of entrepreneur is one who has some capital of 
his own which serves as a guarantee fund and enables him to 
obtain more capital from others. To such a person Professor 
Clark has given the compound title capitalist- entrepreneur?^ I 
shall use that term to denote a person who employs his own 
capital and that of others in the production of commodities, 
who is the original owner of the product of the industry, and 
whose income consists of interest on his own capital and what- 
ever net profit may be realized in the sale of the product. 
Whether speaking of the pure entrepreneur or of the capitalist- 
entrepreneur as above defined, I shall for the most part leave 
out of consideration that portion of his income which is 
attributable to his own labor and which would properly be 
classed as wages. A pure entrepreneur is one who is entre- 
preneur and nothing else, and whose income is normal profit; 
a capitalist-entrepreneur is one who is entrepreneur and 
capitalist, and whose income consists of interest and profit. 
And while, as has been shown, there is no necessary and 

^ This term atones by its definiteness for its lack of brevity. President Hadley 
has used the term speculator with much the same meaning, but this word is used 
in too many other senses to be very precise. Its indefiniteness is probably partly 
responsible for the large but vague part which risk plays in his theory of distribu- 
tion. 



24 THEORY OF RISK AND INSURANCE [306 

universal connection between the recipient of profit and the 
captain of industry, still it may be said that in general it is the 
entrepreneur as here defined, who performs the directive work 
of society. It is his desire to realize a profit by lowering the 
cost of producing commodities which is the main incentive to 
industrial progress. 



CHAPTER I. 



THE NATURE OF RISK. 



To live and labor in uncertainty is the common lot of all 
men. Life and health, property and income, are all exposed 
to countless dangers. The precariousness of the results of 
human effort has been a favorite theme of poets and philoso- 
phers of all ages. "The best laid schemes o' mice an' men 
Gang aft agley," and the possibility of such a mischance pro- 
foundly modifies the conduct of rational beings. In their econ- 
omic activity in particular the influence of uncertainty can be 
clearly discerned. While exact mathematical measurements 
are in the nature of the case impossible, the direction of this 
influence, and to an approximate extent its degree, may be 
ascertained. It has long been considered a commonplace of 
economic theory that the reward of capital, and to a less ex- 
tent the reward of labor, varies directly as the degree of risk 
to which they are exposed as a result of their economic activ- 
ity. But until recently, no attempt has been made to isolate 
the phenomena of risk and risk-taking, and to determine the 
laws which govern them. The new interest in the subject has 
sprung for the most part from discussions as to the exact na- 
ture of the function and reward of the entrepreneur. Professor 
Mangoldt in Germany, and Mr. Hawley in the United States, 
have made independent attempts to elaborate a theory of dis- 
tribution in which the assumption of certain risks shall be the 
special function of the entrepreneur, and his income the reward 
for risk-taking; and though few writers have adopted their 
general doctrine, the notion that in some way the function of 
the entrepreneur has a peculiar connection with risk is by no 
307] 25 



26 THEORY OF RISK AND INSURANCE [308 

means uncommon. In all the previous discussion, however, 
one will search in vain for a thorough treatment of the nature 
of economic risk and the way in which its influence makes 
itself felt. 

We are told by the philosophers that all the activities of the 
universe are obedient to law. Nowhere have they left any 
opportunity for the intrusion of chance. Events which appear 
to take place in a purely accidental way are just as much de- 
termined as those whose occurrence can be accurately foretold. 
The appearance of accident is due entirely to human limita- 
tions. It is because we do not know all the previous condi- 
tions or all the laws governing them that a particular phenom- 
enon appears to us to occur by chance. In this sense, then, 
chance is purely subjective ; it is merely an appearance, result- 
ing from the imperfection of man's knowledge, and not a part 
of the course of external nature. But the term may be used 
also in an objective sense. By chance in that sense is meant 
the degree of probability that a particular event will occur, as 
it is estimated with the aid of all the attainable knowledge of 
the preceding conditions. If the only fact known about the 
condition of a number of balls in a bottle is that there is an 
equal number of white ones and of black ones, there is an even 
chance that the first ball to come out will be white, and this 
chance is independent of any personal peculiarities of the per- 
son who estimates it. It is in this objective sense that the 
term is commonly used, and, to avoid any possibility of ambi- 
guity, it is in this sense alone that it will be used in the follow- 
ing pages. By chance will be meant the degree of probability 
of the occurrence of any future event.' It may vary all the 
way from absolute certainty that an event will not occur, 
through the different degrees of probability, to absolute cer- 
tainty that it will occur. 

' This term may also be used to denote the probability that an event has 
occurred in the past, when it is impossible to obtain any certain information about 
it. Premiums for the insurance of overdue ships are determined partly by the 
chance of loss as estimated from past experience. 



309] THE NATURE OF Risk 2/ 

Chance affects economic activity through the psychological 
influence of uncertainty. Man's conduct is modified in one 
way by coming events which he can definitely foresee and pro- 
vide for, though he can do nothing to prevent their occur- 
rence; it is affected in a different way by events which are only 
possible, and which may never occur, or may occur at an un- 
expected time. In the latter case he will not act just as he 
would if he knew that they would occur, and occur at a 
definite time, and he will not act just as he would if he knew 
they would not occur at all. His conduct will be modified by 
the very uncertainty as to the occurrence of the future event, 
that is, by what appears to him as chance. 

A distinction must be made and kept clearly in mind 
between the chance, or the degree of probability, and the 
degree of uncertainty. Manifestly the greatest degree of 
uncertainty does not accompany the greatest degree of proba- 
bility. When the chance is zero, the uncertainty is also zero. 
A slight degree of probability brings with it a slight degree of 
uncertainty. But the two cannot go on indefinitely increasing 
at the same rate, as at the end of the series we should have 
the absurd combination of the highest degree of probability, 
which is certainty, with the highest degree of uncertainty. 
The uncertainty is the greatest when the chances are even, 
that is, when the degree of probability is represented by the 
fraction ^. In such a case we say that there is nothing to 
show what the outcome will be. As we go from an even 
chance either towards greater probability or towards less 
probability, the uncertainty diminishes, and at either end of the 
series it entirely disappears. For example, there is an even 
chance that the first card drawn from a perfect pack will be 
red or black, and there is absolute uncertainty as to which it 
will be. If, however, one of the red suits is replaced by a 
third black suit, the degree of probability is altered. The 
chance of drawing a red card is now one in four, and the 
chance of drawing a black one is three in four. The chance 



28 THEORY OF RISK AND INSURANCE fsIO 

has been increased or decreased, according to the color whose 
appearance is made the basis of comparison. But the degree 
of uncertainty has been reduced, and this is equally true of the 
uncertainty about the appearance of either color. And after a 
black suit has been substituted for the remaining red suit, the 
chance of drawing a red card has been reduced to zero, and 
the chance of drawing a black card has been increased to a 
hundred per cent., while all uncertainty as to which color will 
be drawn has disappeared. 

I have dwelt at such length upon this simple distinction 
because of its fundamental importance for the determination 
of the nature of risk. The word risk, as it is employed in 
common speech, is by no means free from ambiguity. It is 
sometimes used in a subjective sense to denote the act of tak- 
ing a chance, but more commonly and preferably in an objec- 
tive sense to denote some condition of the external world. 
To avoid ambiguity its use in the following pages will be con- 
fined to this latter sense. The act of incurring a risk will be 
called risk-taking or the assumption of risk. 

But even when used in this objective sense its significance 
is not always the same. It is possible to think of risk either 
in relation to probability or in relation to uncertainty. As the 
degree of probability of loss increases from zero to one hundred 
per cent., the degree of risk may be said to increase pari passu. 
This is undoubtedly the way in which the term is ordinarily 
used. A person who should enter upon an undertaking in 
which the chances were ninety in a hundred that it would 
result in failure, would undoubtedly be said to run a tremen- 
dous risk. But if the term is used in this sense, it will not be 
true, as I shall attempt to show later on, that the special net 
reward for assuming risk invariably increases as the degree of 
risk increases. This net premium increases as the uncertainty 
increases; but after the point of even chances is passed, the un- 
certainty diminishes as the probability increases. Beyond that 
point, therefore, the net premium for risk-taking will also 



21 1] THE NATURE OF RISK 29 

diminish as the probabiHty of the occurrence of the loss in- 
creases. When the loss is certain to occur the premium 
entirely disappears, as in the case of the ordinary replacement 
of capital used up in productive operations. As, however, the 
risks assumed in industrial life are usually well below the point 
of even chances, so that the uncertainty as to the outcome 
increases as the probability of loss increases, it will be more 
convenient to continue the discussion as though such risks 
only were to be considered. Whatever statements are in- 
tended to apply to greater chances will be put in a form that 
will make their application clear. 

This is not the place to undertake to establish the law laid 
down above. My only reason for mentioning it here is to 
show why it seems necessary to define risk with reference to 
the degree of uncertainty about the occurrence of a loss, and 
not with reference to the degree of probability that it will 
occur. Risk in this sense is the objective correlative of the 
subjective uncertainty. It is the uncertainty considered as 
embodied in the course of events in the external world, of 
which the subjective uncertainty is a more or less faithful 
interpretation.^ 

Considering risk in this sense, we find that the method by 
which the degree of risk may be ascertained depends upon the 
relative perfection of the knowledge of preceding conditions. 
In some cases it may be known directly from the circumstances 
attending it. The uncertainty about the color of a card 
drawn at random from a perfect pack is of this kind. No one 
would consider that the chance at the tenth trial was altered 

1 This definition involves considerable departure from ordinary usage. The 
wford uncertainty might be used in this objective sense, or a new term might be 
coined to designate its objective aspect. But it has seemed better to keep to the 
term ordinarily used by economists in this connection. It is important not only to 
develop more clearly than has yet been done the effect of risk on economic 
activity, but also to note that many of the statements commonly made about it 
are true only when the term is defined in this way. 



30 THEORY OF RISK AND INSURANCE [312 

by the fact that at every one of the preceding nine trials a red 
card had been drawn. But when no such definite knowledge 
of proceding conditions is attainable, the degree of risk is esti- 
mated in a different way. It is ascertained by applying the 
laws of probability to the accumulated results of past experi- 
ence. The chance that a particular loss will occur is denoted 
by the fraction expressing the ratio between the actual num- 
ber of such losses and the possible number in a given period 
of time. If during each year for a series of years the loss has 
been one in one hundred in the case of buildings of a certain 
kind, the chance that a similar building will be destroyed dur- 
ing the following year is expressed by the fraction j|^ — on 
condition that there is no appreciable change in the methods 
adopted for preventing loss. If for the moment we assume 
that it is known that the actual number of losses every year 
will correspond with the average number, the only uncer- 
tainty for the group as a whole will be as to which of the 
buildings will be the one to suffer the loss. The chance that 
any particular building will be destroyed will be one in a hun- 
dred, but the number of losses for the group as a whole will 
be fixed. 

But as a matter of fact the loss for the group as a whole is 
not likely to correspond exactly with the average loss as de- 
termined by past experience. The actual number of losses in 
any year will var}^ more or less from the average. This varia- 
tion is not absolutely indefinite. By the laws of chance a 
figure can be obtained which will indicate the probable varia- 
tion of the actual number of losses from the average. This 
figure will vary in different cases according to the nature of 
the series from which the average has been obtained. The 
probable variation will be much less in the case of a series in 
which the losses from year to year have varied little from the 
average, than it will be in the case of a series which shows 
great fluctuations. Thus, to take a simple illustration, if the 
losses for four years have been i, 11, 30 and 18 per hundred. 



J 1 2] THE NA TURE OF RISK 3 1 

the average is 15 per hundred, but it is evident that the actual 
number may vary greatly from the average. If on the other 
hand the series had been 13, 14, 16 and 17, while the average 
would have been the same as before, the actual number for 
the following year would be much more likely to be near the 
average. The probable variation of the actual number of 
losses from the average may be ascertained by calculating the 
average of the actual variations during the series of years 
under observation. Thus in the first illustration given above, 
the variations were respectively 14, 4, 15 and 3, giving an 
average variation of 9. In the second series the variations 
were 2, i, i and 2, and the average was 13^. It is evident,^- 
therefore, that the greater the fluctuations are from year to \ 
year in the number of losses, the greater is the uncertainty as 
to the number which will occur in a particular year. It must 
be borne in mind that risk is connected with the uncertainty. 
If the number of losses may vary from i to 30, the area of un- 
certainty includes the entire number of possible losses; but if the 
number may vary only from 13 to 17, that whatever may be the 
uncertainty about the fate of any particular building, for the 
group as a whole 13 losses can be counted upon, and the area 
of uncertainty includes only the 5 losses from the 13th to the 
17th. 

This distinction between the certain and the uncertain 
losses is of the utmost importance. If, as I shall attempt to 
show, uncertainty imposes a cost upon society, the removal 
of the uncertainty will in itself be a source of gain. Not that 
the replacement of the possibility of a small amount of loss by 
the certainty of a large amount would result in a net gain. 
The effect of the occurrence of disaster is in itself the same, 
whether it was foreseen or not. It is the destruction of a cer- 
tain amount of capital. But the net result of the occurrence 
of a certain amount of loss which was definitely foreseen, is 
dififerent from the net result of the occurrence of the same 
amount of loss, plus previous uncertainty whether it would be 



32 THEORY OF RISK AND INSURANCE [314 

greater or smaller. And the influence of the latter element is 
greater when the anticipation of future loss is based on an 
average obtained from a fluctuating series of past losses. The 
greater the probable variation of the actual loss from the 
average, the greater the degree of uncertainty. 

Finally it must be noted that the probable variation varies 
with the number of cases included in a group. Accordin g to the 
well-known statistical law, the figure denoting the probablevari- 
ation increases only asjthe square-Jloot of the number of cases. 
Increasing the number of similar risks a hundredfold increases 
the~probable v ariat ion b^ only tenfold. If for example we 
assume that past experience, based on the observation of lO.OOO 
cases for a number of years, has shown that on the average 
one house in every thousand is destroyed by fire each year, 
the average loss has been 10 houses a year. But the actual 
loss has varied from year to year. The probable variation of 
the actual loss from the average can be determined only by a 
calculation based on the actual losses during the years under 
observation. But we will assume that for 10,000 cases this 
variation is 5. Then if there is no change in the chance of 
destruction to which the houses are exposed, the loss next 
year will probably be between 5 and 15. It is probable that 
as many as 5 and no more than 15 of the houses will burn. 
The area of uncertainty, then, is 10, or y^^ of i per cent, of the 
number of cases. If we now increase the number of houses 
exposed to the same danger a hundredfold, from 10,000 to 
1,000,000, the average loss will be 1,000, but the probable 
variation of the actual loss from the average will not increase 
a hundredfold, from 5 to 500, but only tenfold, from 5 to 
50. The actual loss next year will probably be between 950 
and 1050. The area of uncertainty is now lOO, or y^^ of i 
per cent, of the number of cases, ^^e lia3i:e- used the _term area 
of uncertainty to denot e the number of cases IvJ^ng between the 
largest probable number of losses, or the average plus the 
prbSable variation, andlhe smallest probable number, or^the 



315] THE NATURE OF RISK 33 

average jpinus.. the probabIe_ variatioii/ . We ni3^L_say then 
plat the area of uncejItaintjMncreas^ej^a^the^square rGat of the 
nurrrbeFoF cases, and that its ratio to the entire number of 
cases becomes coirrespondingly less. 

'Rts1r^'m~\}i\& sense in which we are to use the term, is, so to 
speak, the objectified uncertainty as to the occurrence of an 
undesired event. It varies with the uncertainty iarid^ hot with 
the degree of probabihty. In that sense the degree of risk in 
any individual case is a definite quantity. It may be ascer- 
tained in some cases by direct observation of the conditions on 
which the possibility of the occurrence of the event depends. 
When such knowledge can not be obtained directly, it is 
sought indirectly by a statistical study of the results of past 
experience. The chance of the occurrence of a loss is denoted 
by the fraction expressing the ratio between the actual num- 
ber of losses and the possible number in a given period of 
time. ' The value of this figure varies with the regularity of 
the series from which it has been obtained. There is. greater 
uncertainty about the jiumber of losses that_wiM— ©ee-ittjn a 
given year wlren the average has been obtained from a fluctu- 
ating seneslhan when it has been obtained from one which 
was cofflparatTveTy uniform. The figure expressing the aver- 
age variation T3f'tlie actual losses from the average loss For a 
number of years is_caned the probable variation. The greater 
the ratio between the probable variation and the whole num- 
ber of cases, the greaTier-is the uncertainty. The probable 
variation Increases onl£a^^^ rooj of the number of 

cases, therefore its ratio to the whole number becomes less as 

1 1 need not point out that the average variation itself denotes only a probability 
and not a certainty. There is additional uncertainly as to the extent to which the 
actual variation in any year vi^ill vary from the probable. I have not thought it 
necessary to consider the various devices of the mathematicians for obtaining 
more significant figures than averages. My only purpose is to show that with the 
increase in the number of cases the actual degree of uncertainty for the entire 
group diminishes, and that fact is sufficiently well brought out by the use of crude 
averages. 



34 THEORY OF RISK AND INSURANCE [316 

the number is increased. Consequently the more individual 
cases there are included in a group, the less is the uncertainty 
as to the amount of loss which the group as a whole will 
suffer. The bearing of these laws upon economic conduct, 
and their significance for economic theory, will appear in sub- 
sequent chapters. 



CHAPTER II. 



CLASSES OF RISKS. 



Capital of any kind is exposed to a certain liability of loss, 
but the degree of risk varies greatly in different forms of in- 
vestment. In the same way participation in any form of indus- 
trial activity may bring with it some chance of personal injury, 
but the degree of danger is not the same in all occupations. 
The minimum degree of risk incurred by the choice of capital 
goods rather than consumption goods, or by using one's power 
in any kind of work, does not have the same kind of influence 
on economic activity as the additional risk involved in partic- 
ular employments. The former affects directly the willingness 
of men to labor or to accumulate capital ; the latter affects 
their choice of the manner in which they shall employ their 
labor or capital.^ These two kinds of risk may be called 
economic, because their existence is due to participation in 
economic life. 

There are other risks to which men are exposed, the exist- 
ence of which is not the result of economic activity. In con- 
trast to the former kind these may be called extra-economic. 
Of this kind is the danger of contracting a contagious disease, 
to which all men are more or less exposed, or the possibility 
of the loss of consumption goods by fire or theft. Such risks 
may affect economic activity ; but not in the same way as those 
will affect it which are incurred as an incident of the activity 

1 Cf. Haynes: "Risk an Economic Factor," Quarterly Journal of Economics, 
vol ix, p. 410. Mr. Haynes regards the minimum degree of risk to which all 
capital is exposed as ineffective. Such an adjective, however, can hardly be 
applied to it. It is certainly " effective," but its effect is not of the same sort as 
that of the additional risk involved in some investments. 

317] 35 



26 THEORY OF RISK AND INSURANCE [318 

itself. It is one question how a man will act because he is 
exposed to a certain degree of risk ; it is a different question 
how he will act when the degree of risk depends on his con- 
duct. It is with economic risk alone that we shall be con- 
cerned ; that is, with the risk that a man incurs on account of 
his participation in economic life.' 

If the subjective value which a person puts upon any com- 
modity is higher than its objective exchange value, the loss of 
the commodity will cause a greater feeling of discomfort than 
would be occasioned by the loss of an equally costly article, 
to which no sentimental value attached. It is in general to 
consumption goods that such abnormal values belong. Sou- 
venirs and heirlooms whose market value is slight may be 
prized very highly by their possessors on account of their 
past associations. A particular book or article of furniture 
may become so necessary to the comfort of its owner that the 
loss of it will affect him like the departure of a familiar friend. 
Occasionally the same sort of personal attachment may spring 
up towards some capital good, as the boat used for a long 
time by a fisherman, or the building in which a man's business 
life has been spent. The loss of such a commodity causes a 
certain amount of personal suffering which is not relieved by 
the recovery of its market value; and the risk of losing it will 
have a greater influence than the risk of losing an indifferent 
commodity of equal value. To this possibility of undergoing 
personal suffering through the loss of any commodity may be 
given the name personal risk. It is so rarely that its influence 
is felt in the case of capital goods that it will not be necessary 
to consider it in discussing the risk to capital. A capitalist is 

1 It is conceivable that there may be a diminution of risk instead of an increase, 
as a result of economic activity. Thus wealth invested in government bonds is 
exposed to less danger than wealth in the form of high-priced driving-horses kept 
for pleasure. In such cases the opportunity of avoiding risk will have an influ- 
ence precisely the opposite of that exerted by the necessity of incurring greater 
risk ; but they occur so rarely that they need not be considered in a general dis- 
cussion. 



319] CLASSES OF RISKS 37 

nearly always indifferent about the loss of capital goods 01 
any kind, if he is certain that the full value of the lost property 
will be restored to him. In most of the risks which he 
assumes this personal element is entirely lacking. 

It is very different with many of the dangers to which the 
laborer is exposed. The economic risk which threatens him 
is loss of income. This may be brought about in various 
ways. Sometimes it is attended with great physical suffering, 
as when a painful accident incapacitates him for labor; some- 
times it brings with it freedom from the necessity of toil, as 
when it is due to the impossibility of obtaining employment. 
In neither case will the certainty of obtaining an income equal 
to the one he was receiving make the laborer indifferent to 
the possibility of the occurrence of the event. He will not be 
willing to endure the physical suffering resulting from the 
accident, just because his income will be continued; and he 
will be more than willing to give up the search for employ- 
ment, if he can obtain as large an income without work as 
with it. 

We have here an important distinction between the dangers 
which threaten labor and those to which capital is subjected. 
In nearly all the dangers to which labor is exposed, there is 
involved a considerable share of what I have called the per- 
sonal element, while the dangers threatening capital are 
almost entirely free from it. This fundamental distinction 
brings with it others no less important, relating to the pos- 
sibility of transferring risk, and the effect which this possibility 
has on the conduct of the person who makes the transfer. 
For that reason it seems inadvisable to attempt to deal with 
the two kinds of risk in the same discussion. In the following 
pages we are concerned almost exclusively with risks to cap- 
ital. Whenever it seems necessary to make any statements 
about the relation of labor to risk, they will be expressed in 
such a way as to indicate the class of risks to which they 
apply. 



38 THEORY OF RISK AND INSURANCE [320 

Risks to capital may be classified in various ways from 
different points of view and for different purposes. A classifi- 
cation which is of great importance for the technique of insur- 
ance is based on the nature of the uncertainty. There may be 
uncertainty whether the event will occur, when it will take ,. 
place, or in what ^2.y—^casus iticerUis an, quando, or quomodo'i fy*^ 
Thus, with reference to a particular building, there is uncer- 
tainty whether it will ever be destroyed, when its destruction 
will occur, and whether it will be due to fire or flood, wind or 
lightning. The greater the number of these kinds of risk in- 
volved in a given case, the greater is the resulting uncertainty. 
Insurance companies usually limit their responsibility to losses 
occurring within a fixed time, and in one or more specified 
ways. 

A second form of classification is based on the character of 
the possible loss. There is the possibility that existing wealth 
may be lost by its owner, and the possibility that expected 
future wealth may never be obtained. We may distinguish 
these forms of loss as positive and negative. The destruction 
of a building by fire illustrates the former kind; the failure to 
find the expected market for a commodity is an example of 
the latter. This classification is of importance for the theory 
of risk, since the peculiar form of loss caused by uncertainty 
is entirely of the negative kind. Writers on insurance have 
had in mind much the same distinction in their recognition 
of the difference between present and future values. To a 
certain extent also it corresponds to the distinction between 
loss of capital and loss of income from capital. 

A more fundamental and significant classification of risks 
than any yet noted is based on the distinction betv/een static 
' and dynamic losses. We have already spoken of the differ- 
ence between static forces and dynamic forces, and have shown 
that the conception of the ideal static state, with an absolutely 
unchanging amount of capital apportioned in such a way as to 
be uniformly productive, is inconsistent with the existence of 



32 1 ] CLASSES OF JilSKS 3^ 

risk. For risk involves the possibility of a divergence between 
the expected course of events and the course actually realized; 
and every such divergence will result in a change either in the 
amount of capital or in its apportionment, and so in a dis- 
turbance of the static adjustment. The non-occurrence of an 
expected loss will have this disturbing effect as well as the 
occurrence of an unexpected loss. In this sense, therefore, 
the expression static risk involves a contradiction of terms. 

But we may conceive of a static state of a modified form, 
which shall embrace the element of uncertainty from which 
man's economic life can never be free. In this approximate 
static state certain forms of risk, that is, the possibility of cer- 
tain forms of accidental loss, will still survive. These risks 
may be called static, because their existence does not depend 
upon the occurrence of dynamic changes.^ They are con- 
nected with losses caused by the irregular action of the forces 
of nature or the mistakes and misdeeds of human beings. 
According to the occasion of the loss, they may be further 
subdivided. Some are caused by inanimate forces, as fire, 
wind, or water; others by the action of animal or plant life, as 
moth or mould; others by the carelessness either of the owner 
of the wealth destroyed or of another person, which gives op- 
portunity for the unfavorable action of animate or inanimate 
nature; and still others by the fraud or violence of the crim- 
inally disposed, seeking to appropriate to their own use wealth 
which does not belong to them. All these forms of loss will 
continue while human life endures, and uncertainty as to the 
exact time or amount of loss to be anticipated from these 

^sources involves also the existence of static risk. 
/\. Dynamic risks are those involved in the possibility of dy- 

/ namic changes. Not all dynamic changes, however, are equally 

1 A slight amount of dynamic risk would also be present so long as there were 
slight local changes in the amount of capital, due to the failure of the actual 
course of events to agree with the expected course. Every such minute dynamic 
change would slightly affect values in other parts of the economic system. 



40 THEORY OF RISK AND INSURANCE [322 

important in this connection ; for it is not the change itself 
which constitutes the risk, but the uncertainty about the time 
or amount of future changes. Growth of population and in- 
crease of capital take place with comparative regularity, and 
therefore cause little incidental loss, except in so far as they 
may be necessary to one of the other dynamic changes, and 
pave the way for it. It is with changes in human wants, and 
still more with improvements in machinery and organization, 
that the greatest amount of uncertainty is connected.^ Those 
included in the first of these groups originate on the side of 
"consumption; those in the second, on that of production. To 
some extent the former are capable of being anticipated or 
even controlled, while the latter occur in the most irregular 
and uncertain ways, and to that extent there is greater risk 
connected with the latter than with the former. No one thing 
is more essential for success in modern business than the 
ability to forecast future changes in the desires of consumers. 
It is important to note also that the loss may result from the 
non-occurrence of an anticipated event, as well as from the 
occurrence of one which was not anticipated; and that the 
special cost entailed upon society by the existence of risk will 
have to be borne whether or not the uncertain loss actually 
occurs. 

Examples of the losses caused by these dynamic changes 
are to be found on every hand. The tide of fashionable travel 
turns from seashore to mountains, and large investments of 
capital at ocean resorts lose their value. .Skycles arrd^^ito- 
mobiles are used by people who formerly wanted horses and 

1 Certain short time fluctuations in human wants would exist even in the static 
state. With change of season would come changes in the consumption of com- 
modities; and exceptional events, such as the death of a ruler and the consequent 
general assumption of mourning, would cause temporary alterations in the char- 
acter of the articles demanded. So far as these fluctuations occurred with uni- 
form regularity, they could be provided for with accuracy and would involve no 
risk. So far as the time of their occurrence and the extent of the change could 
not be foreseen, the possibility of such changes would be a form of static risk. 



X. 



J 2 3] CLASSES OF RISK'S 4 1 

carriages, and the value of the latter declines. An unexpected 
change in the fashionable color leaves manufacturers and 
dealers with stocks of goods which they are obliged to sell 
at reduced prices. The effect of improvements in mechani- 
cal and chemical appliances is equally obvious. A system of 
street railways operated by cable was introduced in a western 
city, and when its career of usefulness had hardly begun, it 
was replaced at great expense by a system operated by 
electricity. A flouring mill was fitted up with the best avail- 
able machinery, and within a very short time the new machin- 
ery was discarded, and an improved pattern introduced at an 
expense of hundreds of thousands of dollars. Every invest- 
ment of capital in forms whose usefulness is limited to the 
production of a specific commodity, is exposed to the danger 
of losing its value through discoveries or inventions which 
render it obsolete and useless. 

There is a special form ef'^^iSlililJ risk which needs to be 
pointed out, both on account of the large part it plays in 
modern industrial life and because of its great theoretical im- 
portance. In a state of society like the present, in which 
wealth is increasing at a rate out of proportion to the increase 
in population, there is always a large fund of newly created 
capital looking for favorable investment. This must be used 
either in increasing the supply of existing consumption goods 
or in creating kinds not before produced. These results may 
be reached either through the larger employment of the kinds 
of capital goods already in use, or through the creation of 
new kinds adapted to the production of the old or the new 
consumption goods. If the only investment for the new 
capital were to be found in the creation of consumption goods 
already in use, by methods and machinery now employed, 
the rate of interest would rapidly fall, and there would be 
little opportunity for the realization of profit. To avoid this 
result capital is continually seeking new forms of invest- 
ment. The simplest device is to invent a cheaper method 



42 TIJEORY OF RISK AND INSURANCE \l'2\ 

of creating a commodity already in use. Every improve- 
ment of this kind will yield a temporary profit to the entre- 
preneur who first employs it, but in the end it must result in a 
lower rate of interest on all capital. As a second resource 
additional capital goods of forms already employed may be 
used to create new kinds of consumption goods; or, finally, 
the new capital may be embodied in new kinds of capital 
goods, intended for the production of consumption goods not 
before created. If the new consumption good produced in 
either way is one which men desire, so that as a result of its 
production there is a net increase in the sum of human wants, 
its influence will be felt in the direction of a greater willingness 
of men to labor, a consequent greater demand for capital, and 
a retardation in the fall in the rate of interest. The introduc- 
tion of the new goods and new machinery also offers an op- 
portunity for the realization of^temporary profit by those who 
first produce or use them.^/i^^'p 

, The relation of risk to these different forms of investment of 
new capital is readily seen. In the first case no uncertainty is 
involved, except possibly as to the elasticity of the demand for 
the commodity whose production is increased. In the second 
case there is to be added uncertainty as to the technical result, 
a form of uncertainty which is usually connected to a greater 
or less extent with the introduction of any untried appliance 
or process. With the progress of physical science, however, 
it is evident that this form of uncertainty is being gradually 
eliminated, and that in many cases the successful working of 
the new device can be safely counted upon in advance. There 
is still greater uncertainty involved in the creation of new 
commodities and new machinery for producing them. If the 
new commodity is intended to satisfy an existing need, it may 
be uncertain how far it will accomplish its purpose. The 
claim that it meets a long felt want is hardly sufficient to 
assure its success. If, on the other hand, the commodity pre- 
ced&s the want, and is produced with the expectation that its 



325] CLASSES OF RISKS 43 

own intrinsic merits and extensive advertising will create a 
market for it, the possibility of failure is evidently greatly in- 
creased. Finally, if existing kinds of capital goods are used 
in producing a new commodity which fails to find a sale, they 
can be turned to the employment for which similar machines 
had been used before and thus preserve a part of their value ; 
but if new kinds of machines have to be brought into service, 
besides the element of uncertainty as to the technical success 
of the machine, there is a possibility that the entire investment 
will be lost if the commodity falls dead on the market. 

The investment of capital in attempts to produce new com- 
modities which shall find a ready sale is one of the most char- 
acteristic features of modern industrial life. The rapid ac- 
cumulation of capital, the consequent fall of the rate of interest 
in old forms of investment, and the large gains to be realized 
under our patent system by the creation of a new com- 
modity which appeals to the public taste, combine to push 
production out tentatively in all directions. Large amounts of 
capital are sunk every year in experiments which end dis- 
astrously, and large fortunes are made out of successful ven- 
tures. In order to be able to refer without circumlocution to 
the risk involved in these experiments, it seems best to give it 
a separate name. For lack of a better term let us call it 
developnieiital risk. By that term will be meant the uncer- 
tainty as to the return to be realized from the investment of 
capital in the production of a new commodity or of a new 
capital good, due to the possibility that it may not find the 
expected market, or may not perform the work for which it 
was intended. 

To return now to the general distinction between static 
and dynamic losses, we find that there are several important 
differences between them. A static loss results either 
from the physical destruction of the object, in which case 
the entire loss is a net loss to society, or from the change of 
possession, as the result of carelessness or fraud, which may 



44 THEORY OF RISK AND INSURANCE [326 

or may not in itself involve a social loss, according to the 
efficiency with which the object is utilized by the old and the 
new possessor. A dynamic loss results from a decrease in 
the value of the object, and in a progressive society the 
very conditions which cause the loss to the individual gen- 
erally make it certain that society will be benefited by the 
change. 

In the second place static losses usually affect one unit or 
several units of the same or of different kinds of capital goods, 
while dynamic losses affect all the units of a given class at the 
same time. Fire may destroy one building here and another 
there, while the great majority of similar buildings go un- 
scathed; but an invention which takes the value out of one 
machine takes it out of all similar machines at the same time, 
and a change in consumption which causes a falling off in the 
demand for any kind of commodity affects the value of all 
existing stocks of that commodity in the hands of manufac- 
turers and dealers. 

In the third place static losses occur with more or less 
approach to regularity, if comparisons are made over consider- 
able periods of time, while dynamic losses are very irregular 
in the time and place of their appearance. Statistics show 
that the losses by fire in different decades bear an approxi- 
mately fixed ratio to the possibility of loss. But dynamic 
losses in one period may vary greatly from those in another, 
and in any particular industry the amount to be expected in a 
given time is almost wholly indeterminable. In other words, 
if large groups of similar cases are considered, the uncer- 
tainty as to the amount of the loss to be anticipated from the 
action of static forces is far less than the uncertainty about 
the amount of the dynamic loss. Or, as risk and uncer- 
tainty are correlative, we may say that the risk of dynamic 
loss is greater than the risk of static loss. 

These points of unlikeness between static and dynamic 
losses are of great importance for the technique of insurance. 



327] CLASSES OF RISKS 45 

Because dynamic losses are so irregular and incalculable in 
their appearance, it is impossible to estimate with any approach 
to certainty what funds must be accumulated to meet them ; 
and because when they occur they affect entire classes of 
goods at the same time, it is impossible to compensate those 
who suffer loss, at the expense of others who are exposed to 
the same danger, but are so fortunate as to escape. The 
result is that while dynamic losses are the ones which most 
deserve compensation, because in general they occur through 
no negligence or fault on the part of the persons suffering 
them, and while they are the ones which society can best 
afford to make good, since they are usually accompanied by a 
net social gain, they are also the ones against which the least 
protection is furnished by existing methods of insurance. 

The distinction between static and dynamic losses is as im- 
portant for the theory of risk as it is for the technique of 
insurance, but to attempt at this place to show what economic 
consequences flow from it, would be to anticipate a consider- 
able part of the argument that is to follow. Its significance 
will appear most prominently in the discussion of the activity 
of the capitalist-entrepreneur and its relation to risk. 

Somewhat analogous to the distinction here drawn between 
static and dynamic losses is that made by Mangoldt between 
technical and economic losses.^ A technical loss is due to 
the failure of an investment of capital to yield the physical 
product expected of it. He cites as illustrations an unex- 
pectedly small increase from an investment in agriculture, the 
failure of a machine to perform the work expected of it, and 
the loss of a ship at sea. An economic loss is due to an 
unfavorable discrepancy between the anticipated value of the 
product and the value actually realized. As an illustration he 
cites the case of a railroad, physically, or " technically," able to 
perform the work expected of it, but yielding less than the 

iH. von Mangoldt: Volkswirthschaftslehre, Stuttgart, 1868, p. 184. 



46 THEORY OF RISK AND INSURANCE [328 

usual reward to the capital invested, because the demand for 
its services is not so great as was anticipated.' 

Now it is evident that Mangoldt's economic losses are all 
dynamic. They are connected with improvements in methods 
of production or with changes in human wants. But not all 
of his technical losses are static. The failure of a machine to 
do the work expected of it may be of either kind. It is static 
if the machine is of a form already in use, and its failure to 
work is due to a flaw in its construction, or to the accidental 
destruction of the machine itself; it is dynamic, however, if the 
machine is of a new and untried type, and its failure is caused 
by a mistake of judgment as to the way in which it will per- 
form its work. That Mangoldt includes in the technical 
group this kind of dynamic loss, which I have called develop- 
mental, is shown by his statement that " the danger of failure 
[in the case of technical risks] is naturally greatest where 
there is something essentially new about the commodity, 
means of production, or method."' 

Mangoldt's purpose in making this classification was to 
identify the kinds of risks which according to his theory of 
distribution it is the special function of the entrepreneur to 
bear. In an isolated economy, he says, economic loss could 
occur only as a result of technical loss. When production 
for exchange begins, there arises the possibility of economic 
loss not occasioned by an attendant technical loss, and then 
the entrepreneur appears. He produces goods for exchange, 

1 There is a striking similarity between Mangoldt's classification and that de- 
veloped at greater length by Professor E. A. Ross. (See Uncertainty as a Factor 
in Production, Annals of the American Academy, vol. VIII., p. 92.) Professor 
Ross dwells upon the importance of the distinction between uncertainty as to the 
relation of outlay to product, and uncertainty as to the relation of product to price, 
but it is with their influence upon production that he is primarily concerned, and 
only incidentally does he touch upon their relation to distribution. 

^Ibici., 186. "Am grossten ist natiirlich die Gefahr des Misslingens da, wo es 
sich um etwas wesentlich Neues in Bezug auf Gegenstand, Productionsmittel oder 
Methode handelt. " 



329] CLASSES OF RISKS ^y 

and consequently is exposed to the danger of economic loss. 
It is for bearing this risk that he obtains his special reward. 
I must postpone for the present a complete discussion of Man- 
goldt's theory. To indicate its imperfection it is sufficient to 
point out two things. In the first place it is not true that a 
man living in isolation could suffer an economic loss only as 
result of a technical loss. A Robinson Crusoe might accumu- 
late a stock of some commodity with the expectation that it 
would be of great service to him, and afterwards discover a 
substitute so much more efficient that he would no longer 
attach any value to his former accumulation. In the second 
place no important service to economic theory can be ren- 
dered by a classification of functions which rests on a distinc- 
tion of so little significance as the one that separates these 
two classes of risks. 

Of other classifications of risk which have been attempted I 
will mention but one, and that only because of a question of 
distribution with which its author has connected it. Professor 
H. C. Emery distinguishes risks of production from specula- 
tive risks.^ /~~RIsks of production are enumerated by him with- 
out being defined ; but speculative risks, we are told, are "the 
risks of price fluctuations affecting the whole market, that is, 
the distinctively Conjunctur-risks." It is evident that for the 
most part this classification, like Mangoldt's and Ross's, is 
based on the distinction between uncertainty as to physical 
product and uncertainty as to value ; and as the risk under- 
taken by an entrepreneur who puts new goods on the market 
is not considered, the risks included in the two groups fall for 
the most part under the head of static and dynamic risks 
respectively. Of the risks of production, we are told, some 
" are borne by the laborer, some by the capitalist, most of 
them by the entrepreneur," while the assumption of specula- 

1 Henry Crosby Emery : " The Place of the Speculator in the Theory of Dis- 
tribution," Publications of the American Economic Association, vol. i., no. i. 
p. 104. 



48 THEORY OF RISK AND INSURANCE [330 

tive risks is the function of the speculator, whose economic 
identity it is the purpose of the article to help determine. As 
I shall have occasion to consider some of Professor Emery's 
arguments when I speak of the relation of the speculator to 
insurance, I have thought it best to mention the principle on 
which his classification of risks is based. 

Let us briefly review the conclusions that we have reached 
as a result of the foregoing analysis. The only risks that are 
important for our purposes are those that are incurred as a 
result of participation in economic life. The element of per- 
sonal suffering involved in many losses is a disturbing factor 
which we are obliged to leave out of account. Partly because 
this is usually present in the risks to which labor is exposed, 
and partly on account of the limited extent to which these 
risks can be transferred to other persons, we shall confine our 
attention to the effect of risk on capital and its employment. 

For theoretical purposes the most significant classification 
of economic risks to capital is the division into static and 
dynamic risks. Static risks are those which are inseparable 
from any form of economic activity, and which will therefore 
be present in a stationary society as much as in one that is 
either progressive or retrogressive. They are involved in the 
possibility of loss as a result of the action of the forces of 
nature or of the carelessness or criminality of human beings. 
Dynamic risks are connected with the possibility of loss 
resulting from dynamic changes. As the degree of risk is 
correlative with uncertainty, the greatest amount of risk is 
associated with those kinds of dynamic change that occur 
with the greatest irregularity. Changes in population and 
wealth occur with comparative uniformity, and therefore 
involve little unexpected loss. Changes in human wants are 
less uniform and produce a greater degree of uncertainty. 
Changes in machinery and in methods of production are still 
more irregular in their appearance, and it is with them that 
the greatest amount of uncertainty is connected. A special 



33 1]. CLASSES OF I^ISKS 40 

form of dynamic risk, and one of great importance in modern 
life, is the developmental risk incurred by those who make 
investments of capital in the production of new and untried 
commodities, whether they are intended for consumption or 
for producing consumption goods. 

I need not stop to repeat what has been said about the 
differences between static and dynamic risks, or about the im- 
portance of the other classifications which we discussed. 1 
will close this lengthy chapter with a word of explanation as 
to the bearing which any such classification has upon the 
general theory of risk. So far as the effect of the risk itself 
on economic activity is concerned, its place in any classification 
has practically no significance. Risk is the objective correla- 
tive of uncertainty about the relation between present outlay 
and future return.; Upon a person considering the advisa- 
bility of any investment of capital, the influence of a given 
degree of uncertainty about the outcome will in general be 
the same, whatever may be the location of the uncertainty or 
the source of the possible loss. The only question which con- 
cerns, him is as to the? degree of risk involved. It is in the 
discussion of special phases of the theory of risk, and still 
more in the examination of the different devices which society 
has adopted for counteracting its unfavorable influence, that 
the importance of the classifications given above will appear. 



CHAPTER III. 



THE COST OF RISK. 



Risk and uncertainty are the objective and subjective 
aspects of apparent variability in the course of natural events. 
Whatever effect risk may have on economic activity is 
brought about through the psychological influence of uncer- 
tainty. The fundamental facts of human nature on w^hich the 
doctrine of risk is based are that in economic affairs uncer- 
tainty is in general a disagreeable state of mind, and that the 
disagreeableness increases as the uncertainty increases. This 
means more than that every man prefers a certain gain to a 
probable one oif the same amount, a sure return of five per 
cent, to a possible return of five per cent, which may never be 
realized. It means that l^e prefers a certain return of five per 
cent, to an uncertain return which may be nothing or may be 
ten per cent., with no indication of where it will fall between 
the two limits. As a general rule uncertainty exercises a 
repellent influence in economic life. 

This general statement, however, is subject to numerous 
qualifications. In the first place it is evident that the same 
degree of risk does not have the same amount of influence on 
all men. This may be because different men form different 
estimates of the degree of risk involved in any undertaking. 
In such a case the influence which will be exerted will depend 
upon the subjective estimate of the objective risk; for it is only 
through the subjective uncertainty that the objective fact 
makes its influence felt. It may be because of differences in 
the mental and moral nature of the men. A venturesome, 
self-reliant man may find little unpleasantness, or possibly 
50 [332 



233] THE COST OF RISK 5 I 

even a positive pleasure, in assuming a risk from which a 
timid man would shrink; and on the other hand one with little 
prudence and foresight will readily incur a risk which a more 
rational man would avoid. To some the excitement involved 
in assuming risks becomes so attractive that it is in itself a 
sufficient inducement to lead them to expose themselves to 
almost certain loss. The gambling instinct has entirely over- 
come what may be called in contrast the business instinct. 
The difference may be due to unlike personal relationships. 
A man with others dependent upon him for support will be 
less ready to take chances than one who has only himself to 
consider. Finally, it may be due to inequalities in the amount 
of wealth possessed by the men in question. Other things be- 
ing equal, the man with a large fortune will be less unwilling to 
expose a definite sum to a given risk than one with little wealth. 
In the second place, the same person is not always affected 
in the same way by risks which he estimates alike. This varia- 
tion may be brought about in several ways. It may be because 
of non-economic considerations. If the odor of respectability 
attaches to an uncertain form of investment, while a safer form 
has plebeian associations, these facts may more than counter- 
balance the effect of the larger risk. It may be on account of 
differences in the nature of the risks themselves. Adam Smith 
was the first to point out the unlike effects produced by a great 
chance of winning a small amount, and a small chance of win- 
ning a large amount. Readiness to assume the latter kind of 
risk is frequently far greater than would be justified by its true 
actuarial value. It is to this peculiarity of human nature that 
the excess in the amount of capital invested in certain extra- 
hazardous occupations, such as gold-mining, is partly to be 
attributed. Finally, with changes in a man's economic condi- 
tion, his reluctance to incur risk also changes. As his wealth 
increases the marginal utility of a fixed sum becomes smaller, 
and for that reason his unwillingness to expose it to a definite 
risk also diminishes. 



52 THEORY OF RISK AND INSURANCE [334 

How far the economic behavior of mankind in the face of 
uncertainty is affected by such considerations as these, could 
be determined only by an inductive study. In the discussion 
of the general theory of risk we are obliged to neglect all 
these disturbing elements, and to assume for man's conduct a 
degree of regularity which does not actually prevail. Except 
when a definite statement to the contrary is made, the argu- 
ment proceeds on the assumption that the effect of a given de- 
gree of uncertainty is the same upon all men, regardless of any 
peculiarities in the nature of the risk or of the persons assum- 
ing it. 

The first proposition to be established is that uncertainty in 
economic affairs is an evil, causing a net loss to society in 
addition to all the losses occasioned by the occurrence of 
unfavorable events. A certain amount of capital will be acci- 
dentally destroyed during the coming year. On account of 
the uncertainty as to the amount of loss which will occur, the 
economic condition at the end of the year will be less favor- 
able than it would be if the same loss were to occur, but 
the time and place of its occurrence could be accurately 
foreseen. Or, to state the same thing in a different way, if 
none of the possible accidental loss should actually occur, but 
the present degree of uncertainty should continue, the condi- 
tion at the end of the year would be less favorable than it 
would have been if the uncertainty had been absent as well as 
the loss. 

This net loss, due to the existence of risk, is the result of the 
repellent influence of uncertainty upon normal human beings. 
Uncertainty is a form of disutility which no one will voluntarily 
incur unless something is to be gained by so doing. The 
first place where its influence can be detected is in the accumu- 
lation of capital. If risk were uniform in all kinds of invest- 
ment, the rate of accumulation in a dynamic society would 
evidently depend partly on the degree of risk to which capital 
was exposed ; and with unequal degrees of risk in different 



335] THE COST OF RISK 53 

investments the same relation exists, though it is more difficult 
to trace. 

But this is properly a dynamic question, to which we shall 
return later on. In a static society the effect of uncertainty is 
visible only in the employment of the capital already in existence. 
In an ideal static state capital would be so apportioned that every 
unit of it would be equally productive. The same thing would 
be true of an approximate static state on the assumption that 
there was the same degree of risk involved in all forms of in- 
vestment. But the real world shows no such uniformity of 
risk. The static state which would evolve, if dynamic changes 
were to cease, would be one in which different forms of invest- 
ment would involve unequal degrees of uncertainty. This con- 
dition of things would prevent the perfect static apportionment 
of capital. No one would be willing to make investments in 
hazardous enterprises with the expectation of receiving only 
the same average net return that he could obtain in safe in- 
vestments. The apportionment of capital would be so made 
that the net return in different investments would vary directly 
as the degree of uncertainty involved in them. The flow of 
capital into hazardous enterprises would cease while its mar- 
ginal productivity in them was still enough above its mar- 
ginal productivity in safe investments to yield the additional 
net reward necessary to induce investors to incur the risk. If 
the degree of risk in some form of investment is such that it 
requires a net return of two per cent, above the rate in safe in- 
vestments to induce any capitalist to assume it, there is no way 
in which competition can do away with the extra two per 
cent., so long as the degree of risk remains unchanged. The 
flow of capital into the industry ceases while the return to it 
is still two per cent, above the return in safe investments. 
The extra two per cent, is the incentive necessary to induce 
any investor to incur the risk, and for that reason no one will 
bring down the rate towards the normal level by offering cap- 
ital for a smaller reward. 



54 THEORY OF RISK AND INSURANCE [336 

So far in our discussion we have made no allowance for the 
important consequences of the influence of the law of dimin- 
ishing utility on the reluctance to incur risk. Every unit 
added to a man's wealth has less value to him than the pre- 
ceding unit. If a man with ;^ 10,000 ventures it in an enter- 
prise in which he runs a risk of losing it all or winning an- 
other ;^ 10,000, the ;^ 10,000 he will win in case of success will 
have far less utility to him than the $10,000 he will lose in 
case of failure. And if he ventures onl}/ ^1,000, it is still true, 
in a less degree, that the additional ^1,000 will have less utility 
to him than the niarginal ;^ 1,000 he already possesses. A 
perfectly fair wager, therefore, in which due allowance is made 
for the different degrees of utility of the sum wagered to the 
two parties, is never economically justifiable. Thus if two 
men, to whom ;^ 1,000 has the same marginal utility, wager it 
on the toss of a penny, the one who loses will necessarily lose 
more than is gained by the one who wins. There is a net loss 
to the two by the transaction. 

The effect of this psychological principle is obvious. The 
amount of the extra remuneration which will be required to 
induce the investor to incur a risk is influenced by the dimin- 
ishing utility to him of additional units of capital. If he pos- 
sesses 5 unitsof capital, we may let 10 represent the utility of the 
first unit, 9 of the second, 8 of the third, 7 of the fourth, and 6 of 
the fifth.' Then the total utility of his capital is represented by 40. 
If the utility of additional units continued to diminish at the 
same rate, 5 more would have the utility respectively of 5,4, 
3, 2 and I, or a total of 15. Therefore, he would subject him- 
self to the chance of losing ail his capital or of winning an- 
other equal amount, for this reason alone, only when in his 
judgment the chance of success was to the chance of failure as 
40 to 15 ; and he would incur the risk of losing his marginal 
unit or of gaining another unit, only when the chances were as 

^Adapted from J. B. Clark: "Insurance and Business Profit," Quarterly Jour- 
nal of Economics, vol. vii, p. 44. 



237] THE COST OF RISK 55 

6 to 5. Or if we assume equal chances of success or failure, 
the sum to be gained would have to exceed the sum to be 
lost by a sufficient amount to make the utility of the two 
sums equal. 

It is evident, then, that the effect of man's natural unwilling- 
ness to subject himself to uncertainty in his economic activity, 
reinforced by the effect of the diminishing utihty of successive 
increments of wealth, will be such an apportionment of the ex- 
isting amount of capital among different industries that the 
return to it will vary with the degree of uncertainty. The most 
productive apportionment of capital would evidently be the 
one in which the marginal productivity was the same in all 
industries. The loss which society would suffer in a static 
state on account of the existence of risk would be due to 
the diminution in the productivity of capital caused by its 
uneconomic apportionment. If for the sake of simplicity we 
assume that all the forms of investment of capital are capable 
of being arranged in two groups, such that the risk in the first 
is twice as great as that in the second, capital will be so appor- 
tioned that its productivity in the former will exceed its pro- 
ductivity in the latter. Compared with the productivity under 
the uniform apportionment that would prevail if the risk were 
equalized, the former group will show a net increase, and the 
latter a net decrease. The cost of the risk cannot be ascer- 
tained by subtracting the wealth created by the capital in the 
less productive group from the wealth which would be created 
by the same capital if it were as productive as that in the other 
group. The diminished productivity of that part of the capital 
is partially offset by the increased productivity of the other part 
The cost of the risk is the difference between the net excess of 
the product created in the more hazardous group, as compared 
with the amount that would be created by the same capital in 
a static apportionment, and the net deficiency in the product of 
the other group. 

This net loss due to the existence of uncertainty must not 



56 THEORY OF RISK AND INSURANCE [338 

be confounded with the loss of capital which results from the 
actual occurrence of the uncertain event. The former is always 
of the kind that I have called negative. The existing amount 
of capital and labor would create a certain amount of wealth if 
it were apportioned in the most productive way. It creates a 
smaller amount when the realization of this appoftionment is 
prevented by the existence of risk. The difference between 
these two sums, that is, the wealth whose creation is made im- 
possible by the uneconomic apportionment, is the cost of risk to a 
static society. A full discussion of the connection between the 
chance losses and gains due to the occurrence or non-occurrence 
of uncertain events, and the negative loss caused by the exist- 
ence of the uncertainty itself, can be better undertaken in the 
next chapter, when we come to consider them from the point 
of view of the person who assumes the risk. 

It must be noticed also that the statement that risk or 
uncertainty entails a burden upon society by no means implies 
that society would necessarily be better off if all risk were 
avoided. If the uncertainty involved in existing forms of in- 
vestment could be abolished, with no additional expense for 
protection from accidental loss, and no change in the amount 
that actually occurred, the result would be a saving to society 
of the net loss which the risk now causes. But if the uncer- 
tainty were avoided by withdrawing capital from all invest- 
ments in which more than the minimum degree of risk is 
involved, society would suffer a great diminution of well-being. 
The fact that capital can obtain the extra reward necessary to 
induce it to enter a hazardous employment shows that society 
values so highly the product of the industry that it prefers to 
bear the extra expense rather than content itself with the pro- 
ducts of safe investments. 

We will conclude our discussion of the cost of risk to 
society with a consideration of the distribution of the burden 
among the different categories of economic persons. The 
laborer as such is not affected by inequalities in the degree of 



339] THE COST OF RISK 57 

risk to which different units of capital are exposed. The 
amount of capital in a hazardous investment is limited, and its 
productivity is for that reason abnormally high ; but there is 
nothing in that fact to interfere with the static apportionment 
of labor, which will make its productivity and its reward 
everywhere the same. The immediate return to the laborer 
will be the same in an industry in which the capital is 
exposed to a high degree of risk as it is in one involving little 
risk. 

Obviously this is not true of capital. The principle that we 
are trying to establish is that the return to capital from invest- 
ments with unequal degrees of risk will vary as the uncer- 
tainty varies. The additional reward, however, is not, strictly 
speaking, an abnormal gain, like that which might be obtained 
by a capitalist who controlled the supply of a valuable natural 
product. Other capital is not prevented by an external force 
from coming in and obtaining a share in the extra reward. It 
cannot properly be said, therefore, that some capital gains at 
the expense of the rest on account of inequalities in the risk 
to which it is exposed. The capital in the hazardous invest- 
ment is performing a greater social service, and for that 
reason obtains a greater reward. 

It is upon the consumer that the whole burden of risk in a 
static society would fall. The extra reward of capital can 
be obtained only through the medium of higher prices. The 
commodities produced by the hazardous industries cannot be 
sold as cheap as they would be if the uncertainty were re- 
moved. Whoever consumes any such commodity bears a 
part of the burden of risk. The extra price paid by all the 
persons who use commodities whose production involves so 
much risk that the capital engaged in producing them obtains 
a reward higher than it could obtain under the ideal static 
adjustment, is from this point of view the cost of risk to 
society. But here again allowance must be made for the gain 
which partially offsets the loss. If the prices of commodities 



58 THEORY OF RISK AND INSUKAACE [340 

produced in hazardous industries are higher than the static 
level, the prices of other commodities, produced in industries 
free from risk, must be below that level. The net loss to con- 
sumers would be ascertained by subtracting from the excess 
in price of the former class of commodities the saving made 
by those who purchased the latter class.' 

This brings us to the final point to be noticed in this con- 
nection. The burden of risk is not borne equally by all con- 
sumers, nor is it distributed according to the amounts spent in 
the purchase of consumption goods. A far larger share of it 
is borne by one whose purchases are confined to the products 
of hazardous industries than by one who buys almost exclu- 
sively articles in whose creation little risk is involved. A con- 
sumer might even realize a net gain on account of risk, if it 
were possible for him to confine his purchases to consumption 
goods whose price is below the static level. The burden of 
risk is borne by those who consume the products of the 
hazardous industries, and it is distributed according to the 
amounts spent in the purchase of such commodities, with 
proper allowance for the savings realized from the purchase of 
the abnormally low priced goods. 

The following are the principal points that we have sought 
to establish in the present chapter : Risk affects economic 
activity through the psychological influence of uncertainty. 
Uncertainty is a kind of disutility, and it will not be borne with- 
out some inducement. Its influence is largely enhanced by 
the fact that the utility of successive increments of capital 
gradually diminishes. In a dynamic society the effect of 
uncertainty is seen in a retardation of the rate of accumulating 
capital. In a static society the inequality in the amount of 

^ If the commodity produced in the hazardous industry is a capital good 
instead of a consumption good, the extra cost is first borne by the purchasers of 
the capital good. It hardly seems necessary to point out how it is shifted from 
person to person until it finally rests upon the one who uses the consumption good 
which the capital good helps to create. 



24 1 ] THE COST OF RISK 5^ 

uncertainty involved in different investments causes such an 
apportionment of capital among them that its productivity va- 
ries as the degree of risk to which it is exposed. The most 
advantageous apportionment would be the ideal static condi- 
tion, in which all units were equally productive. The loss of 
productivity caused by the uneconomic employment of exist- 
ing capital is the cost of risk in a static state. This burden is 
borne by consumers, and it is distributed among them accord- 
ing to the relative amounts spent for consumption goods 
whose creation involves comparatively high degrees of risk, 
and for those produced with little or no risk. 



CHAPTER IV. 



THE ASSUMPTION OF RISK. 



The existence of risk in an approximate static state causes 
an economic loss. The assumption of risk, on the other hand, 
is a source of gain to society, and a part of the gain is obtained 
by the risk-takers as their special reward. We will first con- 
sider in what sense and under what conditions risk-taking is 
socially productive, and then examine the nature and amount 
of the net reward received by the person who assumes the 
risk. 

It is evident that risk-taking is not productive in the same 
sense in which capital and labor are. It has no claim to rank 
as a third coordinate productive agent. All wealth is created 
by labor and capital, and by them alone. No one would think 
of attempting to divide the social product into three parts, say- 
ing that one was created by capital, another by labor, and the 
third by risk-taking. The very incongruity of these statements 
is sufficient to indicate that the term productivity, when 
applied to risk-taking, is used in a somewhat loose and inaccu- 
rate way. The fact is that, as we have already shown, inequal- 
ities in the degree of risk involved in different investments of 
capital bring about inequalities in productivity. Capital in a 
hazardous investment will create more product than that which 
is not exposed to risk. It is evidently not the risk taking that 
creates the extra product, but the capital itself 

It would hardly seem worth while to insist on a point which 

is so nearly self-evident if there were not instances of confusion 

of thought resulting from the failure to make this distinction. 

The difficulty may be due to an unconscious attempt to think 

60 [342 



343] ?'^^ ASSUMPTION OF RISK 6 1 

in terms of productivity and sacrifice at the same time. Risk- 
taking is rewarded in the same sense as abstinence, or labor, 
considered as a form of sacrifice; but the reward which it re- 
ceives is no more created by the risk-taking than interest by 
abstinence, or wages by the unpleasant feelings aroused by 
labor. The extra reward is created by the capital that receives 
it. Risk-taking is productive only in the secondary sense that 
it occasions the increase in the productivity of capital. 

Even in this sense it is manifest that the assumption of risk 
is not always productive, but only when it takes place under 
certain conditions. That it is not productive when the risk is 
voluntarily and unnecessarily created, as in the case of a wager, 
is self-evident; for the gain to society from the assumption of a 
risk can never be as great as the loss due to its existence. It is 
only when the risk is a necessary and unavoidable incident of 
socially desirable economic activity that its assumption can be 
advantageous to society. Moreover, there is need of a still 
further limitation. The assumption of an economic risk is not 
per se a good thing for society. It is desirable only when the 
commodity whose creation involves the risk is one for which 
the demand is so intense that it can command a price high 
enough to replace all capital lost in its production, and leave 
a net return at least as large as the usual rate of interest. 

Under these conditions it would be advantageous to society 
to have capital assume all risks in which the probability of 
gain exceeds the probability of loss. The assumption of an 
infinite number of such chances would result in a net gain. 
But we have already seen that the influence of the unwilling- 
ness of men to incur risk, and of the diminishing utility of 
additional increments of wealth, causes the assurhption of 
risks by individuals to stop far short of the point of equal 
chances. A risk will be assumed only when the commodity 
created as a consequence is so important that consumers are 
willing to make good all losses to the capital as a whole and 
to give to each capitalist a special reward for incurring the 
risk. 



62 THEORY OF RISK AND INSURANCE [344 

A clear conception of the nature of the service that the 
assumption of risk within these limits performs, may be ob- 
tained by considering the loss entailed by a contraction of 
risk-taking. We will assume that society has reached an ap- 
proximately static condition, in which the highest degree of 
risk involved in any form of investment of capital may be 
represented by 10, and the extra reward necessary to induce 
capitalists to incur it, by 5. Now let us imagine a slight 
increase in the reluctance to assume risk, so that it would re- 
quire an extra reward 6 to attract capital into the most 
hazardous investment, which was before assumed for the 
reward 5 ; and that the demand for the product of that in- 
dustry is so inelastic that none of it will be consumed at the 
price necessary to yield the larger reward. That commodity 
would no longer be produced. The most hazardous invest- 
ment now undertaken would involve a degree of uncertainty 
which we will represent by 8, and the necessary extra reward 
under the new conditions we will assume to be 4. How 
would society be affected by the change ? 

In the first place, consumers would have lost the entire 
product of the abandoned industries, commodities which they 
wanted with sufficient intensity to make them willing to pay 
the price necessary to yield the extra reward 5 to the capital 
producing them. On the other hand, the capital and labor 
withdrawn from the non-hazardous enterprises would have to 
find employment in fields already occupied. Whatever in- 
dustry any of it entered would yield a larger amount of physi- 
cal product than before. But the price of each commodity 
was already so adjusted as to furnish a market for just the 
amount produced and no more. To find purchasers for the 
new product it would be necessary to lower the price. The 
amount of the necessary reduction would vary in different in- 
dustries according to the elasticity of the demand for the 
different products. In course of time a new adjustment of the 
productive forces would be reached, in which again the supply 



345] 'T^^^- ASSUMPTION OF RISK 63 

of the product of each industry would just suffice to meet the 
demand for it. But the new supplies of commodities of differ- 
ent kinds must be catering to wants of a lower degree of in- 
tensity than those formerly satisfied by the articles produced 
in the hazardous enterprises. This is proved by the fact that 
society was willing to give the extra reward to the capitalists 
who would create the latter. If the productivity of capital and 
labor is measured in terms of social well-being, every unit 
of capital and every unit of labor is now less productive than 
it was before. The result is a slight falling off in the incentive 
to productive effort. In the end there would probably be 
some increase in the consumption of the products of the safe 
investments, some diminution in the amount of capital, and 
some reduction in the length of the labor day. If all these 
things, however, were to be considered as gains, they would 
not be enough to offset the loss that society would suffer 
through its inability to obtain the products of the hazardous 
industry. The social service rendered by the assumption of a 
risk for which society is willing to pay is the satisfaction 
of wants of a higher degree of intensity than would otherwise 
be reached. The result is an increase in the productivity 
of all capital and labor — that is, in their power to minister to 
human well-being. 

So far we have been considering the productivity of risk- 
taking from the point of view of society. We will now con- 
sider it from the side of the risk-taker. In a static state, 
where production and consumption are properly correlated, 
every producer who carries a risk above the minimum will 
receive a special reward for its assumption. Competition can- 
not take it away from him, because no one is willing to bear 
the risk unless he is rewarded for doing so. It is obtained 
through the obstruction which the risk offers to the free flow 
of capital into the investment. There is less of the product of 
the hazardous industry created than there would be if the 
risk were absent. As a result the price is higher than it 



64 THEORY 01- RISK A,\D hXSURAACE [346 

would be under a perfect static adjustment. Out of this 
abnormally high price comes the extra reward for the risk- 
taker. 

This brings out at once the method by which the amount of 
this extra reward is determined. On the supposition that all 
the units of a commodity are produced under conditions in- 
volving the same degree of risk, and that this risk has the 
same influence on all investors, it is clear that the reward 
which may be obtained for assuming it is definitely fixed. If, 
for example, the risk involved is represented by 5, and the 
reward necessary to induce capital to incur it by 2, no one 
can permanently obtain a higher reward for assuming it. 
Capital will continue to come into the industries involving the 
risk, until the increase of product has lowered the price to a 
point where it yields the extra reward 2 and no mpre; and, on 
the other hand, the reward cannot be brought below that 
point, because by hypothesis no investor is willing to incur 
the risk for any less. The amount of the reward to be ob- 
tained by assuming any degree of risk is determined by the 
disutility involved in enduring the resulting uncertainty. 

But it is not the fact that all units of every product are 
created under conditions involving the same degree of risk. 
The demand for some commodity may be so great that a part 
of the supply has to be produced under exceptionally danger- 
ous circumstances. The capital engaged in producing this 
part of it must be rewarded in proportion to the risk to which 
it is exposed. If all other expenses of production are every- 
where equal, the necessity of paying extra for the extra risk 
will make this part of the supply the most expensive. The 
price of all units of the commodity, therefore, will be fixed at 
the point that will cover the expense of producing this portion 
of it. The capital that is exposed to a lower degree of risk in 
creating the same commodity will receive a larger reward 
than the sacrifice of its possessor calls for. This extra gain is 
of the kind which is commonly spoken of as rent. It natur- 



347] ^-^^ ASSUMPTION OF RISK ^c 

ally attaches itself to that portion of the capital which is 
invested in land. 

Nor is it true that a given degree of risk has the same infli^- 
ence on all investors. For various reasons, of which we have 
already spoken, some men are less reluctant to incur risks than 
others. The reward which they will demand will be corre- 
spondingly less. Let us divide all investors into three classes, 
of different degrees of unwillingness to incur risk, so that for 
assuming the risk 5 they will respectively require the extra 
rewards 3, 2 and i. If the demand for the commodities in 
whose production the risk 5 is involved is so great that it is 
necessary to use some of the capital of the most reluctant in- 
vestors in producing them, it is evident that the price of the 
commodity will be fixed at the point that will give these inves- 
tors the extra reward they demand. As the price of all units 
of the commodity must be the same, all capital will receive the 
same extra reward 3. Those investors who would be willing 
to incur the risk for 2 or i will receive a larger reward than is 
made necessary by their individual sacrifice. This extra gain 
might be called a risk-taker's surplus. It is one form of the 
producer's surplus, of which Professor Marshall speaks." 

Making allowance for these inequalities in the degree of risk 
and in reluctance to incur risk, we shall have to modify our state- 
ment of the law which regulates the amount of the reward for 
risk-taking. That reward will be fixed at the point which will 
make the most reluctant investor whose capital is needed will- 
ing to incur the highest degree of risk involved in the crea- 
tion of any part of the product for which consumers are 

1 It hardly needs to be mentioned that we can speak of such a surplus only when 
comparison is made with the sacrifice of the individual investor. According to 
the productivity theory capital is rewarded in proportion to the product it creates, 
and not in proportion to the sacrifice of its owner. Capital that is equally produc- 
tive receives the same reward. The impossibility of correlating individual re- 
wards with individual sacrifices is the rock on which any sacrifice theory of 
distribution goes to pieces. The recognition of the existence of the so-called 
producer's surplus is a virtual abandonment of the whole position. 



56 THEORY OF RISK AND INSURANCE [348 

willing to pay. There is a margin of risk-taking, just as there 
is a margin of labor or of abstinence ; and in the case of any 
given degree of risk, it is the marginal risk-taker whose reluc- 
tance fixes the amount of reward which is obtained for assum- 
ing it. 

It may be well to bring out more clearly than we have yet 
done the exact nature of the net reward for risk-taking. It is 
not always easy to distinguish between the effect of the 
assumption of risk and the effect of accidental gains and losses. 
The statement that the assumption of risk yields a special re- 
ward is not intended to imply that every risk-taker will be 
better off at the end of a year, or even at the end of a number 
of years, than he was when he put his capital into the hazardous 
investment. I do not refer now to the loss he may suffer on 
account of having underestimated the chances of failure or the 
possibility of disaster. Even though all risks could be and 
were accurately estimated, it is evident that all persons who 
assumed them could not fare alike. Some of the possible loss 
would be realized and some would not. One person might 
suffer early and seriously, while another might escape for a 
number of years. Uncertainty as to the amount of loss which 
each investor will actually suffer is an essential element of the 
risk. Without the possibility of varying results for different 
investors there would be no question of risk to consider. 
If the different men formed the same estimate of the risk they 
were assuming, they would naturally make the same prepara- 
tions to meet the accidental loss. The one who was early 
overtaken by it might reach the end of a period of years far 
worse off than he would have been if he had confined himself 
to safe investments. The one who went through unscathed 
would, on the other hand, be far better off The important 
point to notice is that the reward for risk-taking is obtained 
by both the fortunate and the unfortunate investor, although 
its amount cannot be determined directly from the results 
of the two investments. The man who has suffered the loss 



o^g] THE ASSUMPTION OF RISK 67 

whose possible occurrence was foreseen is better off than he 
would have been if his capital had not been abnormally pro- 
ductive; and the man who anticipated the possible occurrence 
of a loss which he did not suffer is also better off on account 
of the abnormal productivity of his capital. The reward for 
risk-taking could be identified only in the case of an investor 
who suffered just such an amount of loss as past experience 
had shown might on the average be expected. The return 
which such an investor would realize from the use of his 
capital would exceed pure interest, or the return in safe invest- 
ments, by a certain amount, which would be the net reward 
for assuming the risk. As it is the degree of uncertainty 
which determines the unwillingness of investors to enter the 
industry, this net reward would vary according to the previous 
uncertainty as to the probable variation of the actual loss from 
the average.' 

Additional light may be shed upon this point by a consider- 
ation of the way in which the extra reward for assuming risk 
is obtained. Let us consider the conduct of a person who is 
planning to use his capital in a more or less hazardous em- 
ployment. He has to look forward to two kinds of losses. 
In the first place he will have to meet certain definite expenses 
involved in replacing various capital goods as they are used 

1 Marshall recognizes the existence of this net premium for risk-taking : " As a 
rule, a person will not enter on a risky business unless, other things being equal, 
he expects to gain from it more than he would in other trades open to him, after 
his probable losses had been deducted from his probable gains on a fair actuarial 
estimate." (Alfred Marshall, Principles of Economics, 3d ed., p. 693.) 

Pantaleoni, on the contrary, apparently overlooks it : " Mere compensation, 
however, for the risk of an undertaking cannot constitute a normal source of rent ; 
for if this compensation has been estimated strictly in proportion to the risk, it 
must, on an average for a number of years, be exactly equivalent to the latter, so 
that the net rent left would be equal to zero ; whilst, on the other hand, if the 
compensation is not commensurate with the risk, it is antihedonic in its origin, 
the disproportion being due to ignorance as to the frequency and magnitude of the 
risk." (Mafieo Pantaleoni, Pure Economics, translated by T. B. Bruce. Lon- 
don, 1898, p. 279.) 



68 THEORY OF RISK AND INSURANCE [350 

up in the process of production. For this purpose he will 
accumulate what is called an amortization fund. In the 
second place he will expect to suffer some loss through the 
occurrence of the events whose possibility constitutes the risk 
of the investment. His accumulation for this purpose is com- 
monly spoken of as his insurance fund. In considering the 
advisability of making the investment, he will allow for both 
these forms of loss, and his decision will depend upon the 
amount of the net return which he may hope to realize. He 
will embark in the industry only on the condition that the 
price of the product is high enough to enable him to accumu- 
late these two funds and to obtain in addition the usual 
reward for the use of his capital. 

Now it is clear that the amounts of the two funds cannot be 
determined in exactly the same way. To meet definitely fore- 
seen losses he can obtain no more than just enough to cover 
them. If he were seeking a larger return, other capital 
would come in, and the price of the product would fall. The 
size of the insurance fund, however, cannot be determined by 
the amount of the actual loss, since it is about the amount of 
loss that will be suffered that the uncertainty exists. If the 
attempt were made to secure enough to cover all possible loss, 
it is clear that other capital would come in and accept a some- 
what smaller return, on the chance that the possible loss might 
not be realized. But it is equally clear that the influx of new 
capital will cease before the price of the product has been 
brought so low that the insurance fund is reduced to the 
amount of the average loss. The amount of the net reward 
for risk-taking will be determined by the relation between the 
size of the insurance fund which can be accumulated, after the 
competition of different investors has reduced it to a mini- 
mum, and the amount of accidental loss which is expected to 
occur. According to the principles which we have sought to 
establish, the influx of new capital will cease while the price 
of the product enables investors to accumulate such a fund in 



35 l] THE ASSUMPTION OF RISK 69 

excess of the probable amount of accidental loss ; and the 
amount of this extra accumulation will be the greater, the 
more the uncertainty as to the variation of the actual loss from 
the average. If we assume that in a series of years the losses 
which an investor suffers just equal the amount which pre- 
vious experience had shown to be the average, he will be left 
at the end of the period with a net gain, which is his reward 
for assuming risk. 

One other point remains to be noticed. In speaking of the 
difference between the amortization fund and the insurance 
fund, the assumption was made for the purpose of convenience 
that it was possible to distinguish between the certain and the 
uncertain loss by some external characteristic, such as the 
source of the loss or the form in which it occurs. The real 
distinction, however, lies in the element of uncertainty itself, 
and nowhere else. Preparation for any kind of certain loss is 
made by means of the amortization fund; preparation for any 
kind of uncertain loss by the insurance fund. Let us illustrate 
this point with an example. 

In certain industries capital has to lie idle during part of 
the year. The idleness in itself causes a loss. To make up 
for it, the capital will have to be abnormally productive during 
the months in which it is active. If the period of idleness is 
the same every year, so that its duration and the consequent 
loss can be definitely foreseen, the amount of the accumulation 
to meet the loss will also be fixed; and, in the absence of other 
disturbing forces, it will be fixed at the amount of the foreseen 
loss. If, however, there is uncertainty about the duration of 
the idleness, there will be the same uncertainty about the 
amount of accumulation which will be necessary to cover the 
loss; and in determining its size, allowance will be made for the 
possibility that the actual loss may exceed the average. In 
the former case we have an amortization fund, and in the latter 
an insurance fund. Finally, if a certain minimum of loss can 
be foreseen, and the only uncertainty concerns the extent to 



THEORY OF RISK AND JASURANCE 



[352 



which the actual loss may exceed the minimum, the accumula- 
tion to meet the certain part of it will be of the former kind, 
and that to meet the uncertain part, of the latter. 

The definiteness which the application of this principle gives 
to the significance of the term insurance is evidently not in 
accord with the ordinary commercial usage of the word. I 
shall refer to that point again when I come to speak more at 
length of insurance as an economic institution. Moreover, it 
is not claimed that investors in all cases actually go through 
the calculations involved in the two ways of making accumu- 
lations. There is usually no literal separation of the amortiza- 
tion fund from the insurance fund. It is the general result 
of an investment by which the conduct of men is influenced. 
Even in those cases in which a definite sum is set aside to 
meet some special form of accidental loss, while this accumu- 
lation is usually spoken of as an insurance fund, it is not cus- 
tomary to make any distinction between the part which is to 
replace the minimum of loss that is certain to occur, and that 
for the additional possible loss, whose occurrence is uncertain. 
The so-called insurance fund is very apt to include the accu- 
mulation to meet all the loss of a certain kind, whether or not 
its occurrence can be definitely foreseen. Still the fact remains 
that the competition of investors with one another will force 
down the amount of the possible accumulations to the point 
where it will equal the amount of the certain loss of all kinds, 
plus the average amount of the uncertain loss, plus an addi- 
tional increment, the size of which will depend on the degree 
of uncertainly as to the actual amount of the uncertain loss, 
and will be in no way affected by the amount of the certain 
loss. 

The conclusions that we have reached in the present chap- 
ter may be briefly summarized as follows: Risk-taking is pro- 
ductive only in a secondary sense ; it increases the productivity 
of capital. The person who assumes a risk under the right 
economic conditions receives a special reward. The amount of 



2^3] THE ASSUMPTION OF RISK yi 

the reward depends on the degree of risk and on the unwil- 
lingness of men to incur it. The reward is obtained through 
the accumulation of a fund to meet future losses. For those 
losses whose occurrence can be foreseen an amortization fund 
is accumulated. Its size is fixed by competition at the amount 
of the foreseen loss. For those losses whose occurrence is un- 
certain an insurance fund is accumulated. Its size exceeds the 
probable amount of loss as determined from past experience. 
The excess varies with the degree of uncertainty about the 
amount of loss that will be suffered. This extra accumulation 
is the reward for risk-taking. 



CHAPTER V. 

THE REWARD FOR RISK-TAKING. 

In our discussion hitherto we have as far as possible avoided 
the use of language which involved a prejudgment as to the 
economic character of the reward for risk-taking. It is now 
time to turn our attention to the consideration of this phase 
of the question. We shall seek to determine under which 
of the categories of distribution the reward for assuming risk 
falls. Incidentally we shall have to notice one or two of the 
attempts that have been made to identify this peculiar reward 
with the income of the entrepreneur. In conclusion, we shall 
consider the advisability of adopting the suggestion that the 
reward for risk-taking be made an independent category of 
distribution, coordinate with wages, interest and profit. 

It seems to be a self-evident proposition that no one can 
assume a risk in economic affairs unless he has something to 
lose. As it is capital that is exposed to danger, it would seem 
that it must be the owner of the capital, that is, the capitalist, 
who assumes the possibility of loss. A society in which one 
class of people owned the capital, and another class enjoyed the 
unrestricted privilege of exposing it to risk, would soon suffer 
economic shipwreck. It is the possessor of capital who is 
interested in its safety, and he seeks to protect it by demand- 
ing for its use a return commensurate with the chance of loss 
to which it is exposed. In just what sense a man can be said 
to run a risk of loss, who has nothing to start with, and who, 
therefore, cannot fail to come out from his venture at least as 
well off as he went in, it is not easy to understand. Only 
those who have capital can suffer the loss of capital. There- 
72 [354 



355] ^^^ REWARD FOR RISK-TAKING 73 

fore, it is they alone who can expose themselves to the chance 
of loss. Unless, then, we are to limit the term capitalist to 
those who use their capital in ways involving no more than 
the minimum amount of risk, the conclusion is unavoidable 
that the one who assumes a risk to capital is in all cases a 
capitalist. 

It is nearly as self-evident that under normal conditions the 
person who assumes a risk is the one who will receive the 
special reward. By what inter-play of economic motives 
would a capitalist be led to take upon himself the disutility 
involved in subjecting himself to uncertainty, while surrender- 
ing to another the right to the extra product created by his 
capital because of the uncertainty? No one need expose his 
capital to more than the minimum degree of risk unless he 
receives more than the minimum reward for the use of it; 
therefore, if the economic motive prevails, the assumption of 
risk and the receipt of the reward for it will be acts of one 
and the same person. As it is the capitalist who assumes the 
risk, it is the capitalist who will normally receive the reward 
for risk-taking. 

The same fact may be shown more directly by considering 
the source of the net reward. The attempt has been made in 
the preceding chapters to prove that the reward for risk-taking 
is created by the capital exposed to the risk. In a static state 
every unit of capital will obtain as its reward the part of the 
product that is specifically imputable to it. Therefore, the 
owner of the capital that is abnormally productive on account 
of the risk to which it is exposed will receive the extra prod- 
uct. To claim that this extra product may normally accrue to 
some one other than the owner of the capital that created it, 
is to adopt a system of distribution under which some men 
are able regularly to appropriate wealth created by the capital 
of others. Such a view is irreconcilable with a productivity 
theory of distribution, which gives to every agent the product 
that it creates. It is in this case equally irreconcilable with a 



74 THEORY OF RISK A XD INSURANCE [056 

sacrifice theory of distribution, since the entire burden of the 
disutility of risk-taking must evidently be borne by the person 
who is actually exposed to the possibility of loss. 

The net return to capital from a productive operation is 
economic interest. It is the part of the net product that is 
created by the capital. It is customary, however, to make a 
distinction between the product of capital in an industry where 
competition prevails, and its product in an industry where the 
capitalist possesses a monopoly advantage. In the latter case^ 
a part of its product is called a monopoly gain, or a monopoly 
profit. But the difference between the return to capital in the 
competitive industry and its return in the monopolized one is 
not a difference in kind. In both cases it receives the part of 
the product that it creates. It is entirely a question of con- 
venience whether we shall say that the rates of interest are 
unequal in the two industries, or that the rates of interest are 
the same and the extra reward is a monopoly profit. In every 
instance of an abnormally high interest rate, the excess is due 
to the possession of a monopoly advantage by the owner of 
the capital. It is important, however, to distinguish between 
two kinds of monopoly. There is one kind that is founded 
in the nature of things and another that is artificially created. 
The capitalist who exposes his capital to risk has a quasi- 
monopoly advantage of the former kind. The obstruction 
that prevents the free flow of capital into a hazardous invest- 
ment is not maintained by the owner of the capital already in 
it. The monopoly is due to the unwillingness of other capital- 
ists to enter the industry. Its effect, unlike that of permanent 
artificial monopolies, is to promote the best use of capital 
under existing conditions. The amount of the reward for risk- 
taking is determined by direct competition, while monopoly 
profit is determined by the principle of the maximum net 
revenue. 

In the case of capital in hazardous investments, however, as 
in the case of a true capitalistic monopoly, it is a matter of con- 



257 1 ^-^^ REWARD FOR RISK-TAKING 75 

venience whether we shall give the name interest to the entire 
net return to capital, or divide it into two parts and call one 
pure interest, and the other reward for risk-taking. The im- 
portant point to notice is that there is no difference in nature 
between the two incomes. Both are created by capital, and 
both accrue to the capitalist, and the amount of both is deter- 
mined on competitive principles. This fundamental unity in 
the nature of the two incomes seems to be better brought out 
by applying the term interest to both. We should say, then, 
that under the influence of risk, capital will be so apportioned 
in a static state that the rate of interest in different investments 
will vary with the degree of uncertainty involved in them. In 
this interest may be distinguished two elements, pure interest, 
equal in amount to the return to capital in the least hazardous 
investments,^ and the reward for risk-taking, the additional re- 
turn which capital in a more hazardous investment receives.^ 

It is not unusual to divide the gross return to capital, over 
and above the amount necessary to make good the part regu- 
larly used up in productive operations, into pure interest and 
insurance premium. Here, as before, pure interest is the re- 
turn to capital in safe investments, but the so-called insurance 
premium is by no means the same thing as the net reward for 

^ It may be well to state that all disturbing forces except risk, such as social 
esteem and difficulty of realizing on an investment, are here left out of considera- 
tion. The assumption is that there exists a perfect static adjustment of capital, 
except for the influence of risk. 

It is also necessary to bear in mind the distinction between the capitalistic 
monopoly mentioned above, in which the possessor of the capital receives the 
extra product, and an entrepreneur's monopoly, as in the case of the ownership of 
a patent right, in which the entrepreneur obtains his capital at the market rate and 
appropriates the extra product. 

2 Pure interest, as thus defined, is not to be confounded with normal, or static 
interest. The latter is the reward that capital would receive if it were so appor- 
tioned that all units of it were equally productive. Pure interest is the reward re- 
ceived in safe investments under an apportionment of capital in which the produc- 
tivity varies with the uncertainty. Pure interest, therefore, will always be belovf 
the static level. 



76 THEORY OF RISK AND INSURANCE [358 

risk-taking. The purpose of the insurance premium is the re- 
placement of capital accidentally destroyed. It does not, as a 
whole, form a part of the net interest on capital. Out of the 
insurance fund are to be paid all the losses of an uncertain 
character. Whether the fund will exceed or fall short of the 
amount necessary to make good the losses cannot be known 
beforehand, but, as we have already shown, every capitalist 
will require a large enough gross return on his capital to 
enable him to set aside an insurance fund in excess of the 
probable amount of loss as determined by the average of past 
experience. This excess constitutes the net reward for risk- 
taking. So, in the case of commercial loans on doubtful 
security, it would be a mistake to regard the entire excess 
above the rate on government bonds as net reward for assum- 
ing risk. In the absence of other disturbing influences, the 
reward for risk-taking is the part of the extra return which 
would be left after deducting an amount large enough to cover 
the probable loss. It is a matter of common observation that 
inexperienced investors are apt to be unduly influenced by the 
apparently high rate of interest in unsafe investments. They 
do not make sufficient allowance for the losses, the possibility 
of which is the cause of the high nominal interest. It may be, 
therefore, that the net return on investments of this kind is be- 
low rather than above the return in safe investments. This 
fact, however, constitutes no exception to the general rule that 
when risks are properly estimated and appreciated, the net 
rate of interest will vary in different investments according to 
the risk involved in them. 

That the reward for risk-taking is created by capital and is, 
therefore, an element of interest, would probably never have 
been questioned but for the confusion that has resulted from 
attributing a very complex form of activity to the entrepreneur. 
It may be worth while to take up directly the question of the 
relation of the income of the entrepreneur to the reward for 
risk-taking. 



359] "^"^ REWARD FOR RISK-TAKING 77 

The income of the entrepreneur is called profit. In what 
sense the term profit must be understood, in order that it may 
denote an income of a different nature from wages and interest, 
has been pointed out in the Introduction. In only one respect 
does it resemble the reward for risk-taking. Both incomes are 
due to abnormally high productivity in some part of the 
industrial system — both are quasi-monopoly gains. The 
monopoly advantages in the two cases, however, are not of 
the same kind. Profit is due to a local and, in a sense, un- 
natural advantage, which is transient in its character, since it 
can endure only so long as others are prevented from making 
use of the device which is the source of the superiority. The 
reward for risk-taking is due to an advantage the existence of 
which is founded in the nature of man, and which will endure 
so long as man's unwillingness to incur risk remains un- 
changed. Competition will sooner or later annihilate all 
profit, but it cannot abolish the reward for risk-taking. Profit 
is a dynamic income ; it appears as the result of a dynamic 
change, and disappears when the inequality in productivity 
due to the change has induced sufficient movement of capital 
and labor from group to group. Reward for risk-taking is a 
static income ; it will be present in the approximate static 
state which alone can be realized while risk exists ; other 
capital will not flow in to cut down the reward to the capital 
already receiving it, since without the full reward no capital 
will assume the risk. Profit is a residual income, realized by 
the sale of the product at a price above the cost of production, 
and its amount, therefore, can not be determined until the 
price is known ; reward for risk-taking is a direct income, 
whose amount is determined by circumstances preceding the 
sale of the product, just as wages and interest are determined. 
Reward for risk-taking is a part of the cost of production ; 
profit is the surplus over and above the cost of production. 

The attempt to identify the reward for risk-taking with 
profit runs counter to the obvious fact that there is no uniform 



yS THEORY OF RISK AND INSURANCE T^^q 

relation between the amount of profit and the degree of risk. 
A large profit may be obtained under conditions involving 
little or no risk. The gain from the introduction of an im- 
proved method of manufacture may be manifest as soon as the 
improvement is thought of; and the adoption of the new de- 
vice, while involving no risk, may lead to the appearance of a 
considerable profit. On the other hand, risk may perfectly 
well be involved in a form of investment in which no profit is 
appearing. The manufacture of explosives is an industry in 
which a fluctuating amount of accidental loss will always be 
suffered; but in the absence of dynamic changes the possibility 
of obtaining a profit in that industry would not exist. Indeed, 
in a dynamic society a profit may be obtained by adopting an 
improvement whose only purpose is to lessen the chance 
of uncertain loss, and thus reduce the risk. Such a profit is 
not the reward for risk-taking, but the result of abolishing 
risk. Like all other profit it is transient, and will disappear 
as soon as the improvement has been generally adopted. It 
is manifest, therefore, that there is no necessary connection 
between degree of risk and amount of profit. 

It has been said that just because profit is a residual income 
it is an uncertain one, and that it is for the endurance of this 
uncertainty that the entrepreneur receives his reward. The 
first statement is obviously not true. As I have already 
shown, an income is not necessarily uncertain because it is 
residual. But if that difificulty is overlooked, it is not easy to 
understand the rest of the statement. We are asked to think 
of profit as a reward paid to a person for assuming a risk 
of obtaining no profit. Why should a reward be paid for 
assuming a risk of which the outcome must be either a gain 
or no loss? Clearly the incurring of such a risk involves no 
disutility, and therefore no special inducement is required to 
assure its assumption. Moreover, even if such a notion were 
conceivable, it would still be necessary to show a constant re- 
lation between the degree of uncertainty as to whether a profit 



^61] THE REWARD FOR RISK-TAKING yg 

will appear and the size of the profit; and that is as impossible 
as it is to prove such a relation between profit and risk as 
ordinarily understood. 

The fact that reward for risk-taking is no part of profit, the 
income of the entrepreneur, may be proved also from the 
method in which an industry is established. Let us for the sake 
of simplicity assume an organization of society in which cap- 
italists and entrepreneurs are distinct persons, and in which 
the entrepreneur performs the organizing and directing work. 
The capitalists furnish the capital used in the productive oper- 
ation and receive in return interest, the rate of which is fixed 
in advance ; the entrepreneurs direct and manage the industry, 
hire the capital and labor, pay all the expenses of production, 
and receive as their special reward any profit that may be real- 
ized. Under such circumstances, will it be the capitalist or 
the entrepreneur who will obtain the reward for assuming risk ? 

There are only two ways in which the entrepreneur can 
realize a net gain because of the existence of risk. He must 
be able either to obtain his capital at a rate that does not in- 
clude the reward for assuming risk, or to sell his product at a 
price higher than is necessary to enable him to pay the reward 
for risk-taking. Is it possible for him to adopt either of these 
plans ? 

As the entrepreneur has no capital to act as a guarantee 
fund for the capitalist, it is evident that the latter must look to 
the success of the enterprise for the safety of both principal 
and interest. He will calculate the risk of loss that he is 
assuming, and will demand a return in proportion to it. Now 
the reason why he is able to obtain pure interest on his capital 
in a safe investment is that the entrepreneur can obtain capital 
from no one else without paying the interest. Why, then, 
should he forego the extra reward for risk-taking in a hazard- 
ous investment when the entrepreneur must pay the extra re- 
ward to any other investor whose capital he may seek to 
obtain ? No economic motive for such conduct can be con- 



8o l^HF.ORY OF RISK AND INSURANCE [^62 

ceived. The entrepreneur will have to pay for his capital a 
price proportionate to the risk to which it is to be exposed. 
Moreover, as we shall see, if capitalists did not demand the 
extra reward, entrepreneurs would be unable to appropriate 
any part of it as their own income. 

Mangoldt and others have attempted to divide the reward 
for risk-taking into two parts, and to assign one part to the 
capitalist and the other to the entrepreneur. A special kind 
of risk, called by some economic, by others industrial, is said 
to be assumed by the entrepreneur, and the reward for assum- 
ing such risks is either identified with profit or considered to 
be a part of it. But it seems clear that there can be no ground 
for such a distinction, on our assumption of a complete sepa- 
ration of the functions of entrepreneur and capitalist. As the 
entrepreneur has nothing to lose, it is impossible for him to 
assume a risk of any kind; and as the capitalist bears the 
entire risk, there is no reason why he should be any more 
willing to suffer loss in one way than in another. It is all one 
to him whether he loses his capital through a technical failure 
or an industrial one. It is not reasonable to suppose that he 
would demand a consideration for assuming the risk of loss in 
one way and gratuitously assume a risk of another kind. 
Finally, if all capitalists did act in that uneconomic way, it 
would be impossible, as I shall show presently, for the en- 
trepreneur to obtain any extra gain on account of the indus- 
trial risk. 

It seems clear, then, that as no capitalist will incur a risk 
of any kind unless he is rewarded for it, no entrepreneur can 
obtain capital without paying a price proportionate to the risk 
to which it is to be exposed. Does the existence of risk make 
it any more possible for him to obtain a price for his product 
that will leave him a net gain? In the long run the price he 
can get is determined by the expense of production. Only 
when he is obtaining a higher price is he realizing a profit. 
The existence of such a profit in any part of the industrial 



363] "^^^ REWARD FOR RISK-TAKING 8 1 

system is an invitation to other entrepreneurs to come in and 
share it. If, then, we assume that an entrepreneur who is 
using capital in a hazardous industry is obtaining a price for 
his product that leaves him a net profit after paying for his 
labor and capital, with the reward for risk-taking included, it 
is clear that such a profit would soon be annihilated by the 
competition of other entrepreneurs. 

The same thing would happen to the extra gain that an 
entrepreneur would realize if capitalists as a class should sud- 
denly become willing to forego the reward for assuming either 
all kinds of risk or a special kind. The necessity of exposing 
capital to the chance of loss can have no terrors for the entre- 
preneur, since the loss will not fall upon him, but upon the 
capitalist. If, then, all capitalists consent to assume risks for 
nothing, all entrepreneurs will be able to obtain capital for 
purposes involving risks at a lower rate than they formerly paid; 
and the competition of entrepreneurs with one another will 
prevent any one of them from keeping the price of the product 
above the level that his reduced expense justifies. If capitalists 
incur risks without any extra inducement, it will be consumers, 
and not entrepreneurs, who will benefit by their forbearance. 

For the entrepreneur the reward for risk-taking is an ele- 
ment in the cost of production. The price of a commodity in 
whose creation risk is involved is higher than it would be if 
the risk were absent. The gross return to the entrepreneur is 
greater. The entire excess, however, due to the existence of 
risk, he has to hand over to the capitalist ; for the amount of 
the extra return that he can secure on account of the risk is 
fixed by the extra interest that he is compelled to pay for his 
capital. 

The most consistent attempt that has been made to identify 
entrepreneur's profit with the reward for risk-taking is that of 
Mr. Hawley.' Many of the arguments with which he defends 

1 Frederick G. Hawley : " The Risk Tlieory of Profit," Quarterly yournal of 
Economics, vol. vii, p. 459. 



82 THEORY OF RISK AND INSURANCE [364 

his position have been considered in the comparison already- 
made between the two forms of income ; but there is at the 
basis of his contention a misconception concerning the sig- 
nificance of the term productivity as appHed to the assumption 
of risk, to which it may be well to devote a little attention. 
It is most clearly brought out in the following passages. Pro- 
fessor Clark, he says, " acknowledging that the reward of risk- 
carrying exists and has hitherto escaped recognition, and that 
it constitutes a peculiar form of income, . . . refuses to ac- 
company me in identifying it with profit, and claims that the 
reward of enterprise inures to the capitalist as such, and not 
to the entrepreneur as such, thus making the capitalist unique 
among producers, in that he alone enjoys two quite distinct 
forms of income, the one springing from the use and the other 
from the venturing of the capital, but both accruing to him in 
his peculiar industrial function." " It is not of course impos- 
sible," he continues, " that the exercise of a single function 
may be followed by two radically distinct classes of results. 
But it appears to me as an axiom of scientific method, that two 
radically distinct classes of results shall not be ascribed to the 
same function as their source." And yet again : " According 
to Professor Clark, if I rightly comprehend him, we have in 
economics a problem of four forces, producing five distinct 
classes of results — land yielding rent, labor yielding wages, 
capital yielding interest and reward for risk, and co-ordination 
(if he will allow me to so name the force) yielding profit." 

In spite of the ambiguity involved in Mr. Hawley's use of 
the term " enterprise " to denote the activity of the entre- 
preneur, we seem to be justified in inferring that according to 
his idea it is by virtue of his assumption of risk that the entre- 
preneur obtains a profit, and that the reason for distinguishing 
the reward for risk-taking from interest, and assigning it to a 
separate productive agent, is to be found in the necessity of 
assuming distinct functions as the sources of " radically dis- 
tinct classes of results." Now it may be " an axiom of scien- 



365] ^^^ REWARD FOR RISK-TAKJNG 83 

tific method that two radically distinct classes of results shall 
not be ascribed to the same function as their source," but the 
principle has no application in the present case. There is no 
such difference in the natures of the two incomes, interest and 
reward for risk-taking, as Mr. Hawley seems to imagine. I 
have already shown that risk-taking is productive only in a 
secondary sense ; it increases the productivity of capital. 
Capital creates the reward for risk-taking, and receives it as a 
part of its net income. It receives a higher rate of interest in 
a hazardous investment than in a safe one, but the additional 
return differs in no essential respect from the minimum return, 
to which the term pure interest is applied. 

Mr. Hawley proposes to put in a separate category of dis- 
tribution the excess of interest that capital receives as the re- 
sult of assuming risk. If he should follow his method of 
analysis to its logical conclusion, he would have to treat in the 
same way every other excessive increment in the return to 
capital. Risk is not the only thing that prevents the static 
apportionment of capital. Social odium, for example, may 
have the same result. If the investment of capital in any kind 
of business brings with it loss of public esteem, an abnormally 
high return will be necessary to induce capital to enter it. The 
marginal productivity of capital in the industry will be above 
the static level, and the rate of interest will be correspondingly 
high. But Mr. Hawley would hardly be willing to carry out 
the principle he has laid down and regard the incurring of 
social odium as a separate economic function, creating and re- 
ceiving a radically distinct share of product. There is no 
more reason for making such a distinction in the case of the 
abnormally high interest that capital receives as a reward for 
incurring risk.' 

We have seen that the attempt to identify reward for risk- 

^ Mr. Hawley's classification of incomes fails to make any disposition of profit, 
as the term is here used. It is not a part of wages or of interest, and if the pre 
ceding argument is sound, it by no means corresponds to the reward for risk-taking. 



84 THEORY OF IRSK AND INSURANCE [366 

taking with entrepreneur's profit is based on a misconception 
of the nature of the two incomes, and that the recognition 
of this reward as a separate category of distribution cannot be 
justified on the ground that the reward is created by a distinct 
economic agent. But the suggestion has been made' that it 
might be well for other reasons to give that form of income an 
independent place in the scheme of distribution. Without 
stopping to consider the arguments that have been advanced 
in favor of such a course, I may mention two or three that 
seem to me to be conclusive against it. 

If the new category were to include the extra reward that 
labor sometimes obtains in dangerous occupations, as well as 
the extra reward of capital, it would be found impossible to 
make much practical use of it, on account of the different prin- 
ciples by which the two rewards are determined. Moreover 
the inclusion of a part of wages and a part of interest in one 
group would cut across the classes already recognized, and 
seriously impair the significance of the classification. 

If, on the other hand, it is proposed to have the new cate- 
gory include only the extra reward that accrues to capital on 
account of risk, the objections to the plan are no less weighty. 
In the first place it is inexpedient. It places the emphasis on 
the points of unlikeness between pure interest and the reward 
for risk-taking, when it is more important to bring out their 
essential likeness. Clear economic thinking will be promoted 
by establishing the distinction between the reward for risk- 
taking and profit, and in no way can that be better accom- 
plished than by showing the identity of the former income 
with interest. In the second place it is unscientific. It com- 
pletely destroys the coordination of the classification. To 
divide incomes into profit, wages, interest, and the reward for 
risk-taking, is much like dividing material bodies into inani- 

* T. N. Carver, " The Place of Abstinence in the Theory of Interest," Quar- 
terly yournal of Economics, vol. viii, p. 58, note. 



367] THE REWARD FOR RISK-TAKING 85 

mate objects, plants, animals, and men. There are reasons 
why it is important to distinguish the reward for risk-taking 
from other interest, just as there are reasons for distinguishing 
men from other animals; but to make a separate and distinct 
class out of a subdivision of a class already recognized is to 
do violence to scientific method. 

Wages, interest and profit are independent, exhaustive, and 
mutually exclusive forms of income. Reward for risk-taking 
may be a part of wages or it may be a part of interest; it has 
no independent standing, and therefore it has no claim to rank 
as a coordinate category of distribution. It is best to abide 
by the existing classification of incomes, and to think of rates 
of wages or of interest as varying in different employments 
under the influence of risk. 

In the present chapter we have attempted to show that the 
reward for risk-taking is neither the whole nor any part 
of profit, and therefore does not accrue to the entrepreneur; 
that it is a part of interest and accrues in all cases to the cap- 
italist; and that it is inexpedient and unscientific to make it an 
independent category of distribution, coordinate with wages, 
interest and profit. 



CHAPTER VI. 

WAYS OF MEETING RISK. 

Up to this point in our discussion we have proceeded 
as if the degree of risk involved in any enterprise were an 
unchangeable quantity, which the investor must in all cases 
assume if he decides to enter the industry. As a matter of 
fact, however, the degree of risk may be changed by the con- 
duct of the investor himself The adoption of devices for 
lessening the chances of accidental loss, and for diminishing 
the unfavorable influence of uncertainty, is one of the most 
important forms of progress in a dynamic society. How 
much risk w ould be involved in different industries in the 
approximate (stati^ state, and how much deterrent effect a 
given degree of risk would have on investors of capital, would 
depend on the stage of economic development that the society 
had reached before dynamic changes ceased. We must now 
turn our attention to a consideration of the devices that have 
been adopted by society to counteract the unfavorable in- 
fluence of risk. Some of these may be carried out by an 
individual investor; others require the combined action of two 
or more men, and are therefore of a social nature. We will 
begin with those that do not require social cooperation. 

A man living in isolation may carry on certain productive 
operations and accumulate a limited stock of capital goods. 
Let us imagine that he has cleared a piece of land and fash- 
ioned tools with which to work it. On half the land he is 
able to raise all of some crop, as potatoes, that he cares for ; 
he is considering whether he shall raise corn or tobacco on 
the other half The circumstances on which his decision 
86 ' [368 



369] WAYS OF MEETING RISK 87 

depends are these : He would much rather have a crop of 
tobacco than a crop of corn ; the cost in labor and in wear and 
tear of his capital is the same in the two cases, if he cultivates 
the tobacco in the easiest way; but there is considerably- 
more uncertainty about the size of the tobacco crop than about 
that of the corn crop. Under such conditions it is evident 
that his choice between tobacco and corn will depend on the 
relation between the excess of the utility of the tobacco over 
that of the corn, and the disutility of the uncertainty about the 
amount of tobacco he will obtain. 

It may be that the uncertainty in the case of the tobacco 
can be diminished by a change in the method of cultivation. 
Let us suppose that it is due to the occasional failure of a crop 
on account of prolonged drought. It may be possible to 
adopt measures to guard against the loss. If the tobacco is to 
be raised, any change in the method of cultivation that lessens 
the chance of loss without increasing the cost in labor and 
capital will evidently be adopted. If the tobacco would suffer 
less on that part of the land where the potatoes had been 
raised, while the latter would do as well on one part as on the 
other, the change of location of the two crops would certainly 
be made. If, on the other hand, the method of counteracting 
the effect of the drought involved additional cost, the decision 
as to the advisability of adopting it would not be so easy to 
reach. It might be possible by a system of irrigation to lessen 
or even to annihilate the danger of loss from drought ; but the 
introduction of such a system would involve more or less 
additional cost. On what principle would the choice be made 
between the two possible methods of cultivation ? It would 
evidently be by a comparison of disutilities. The disutility of 
the additional sacrifice incidental to the introduction of the 
system of irrigation would be set over against the disutility 
of the uncertainty involved in raising the tobacco without 
artificial irrigation. If the former were less than the latter, 
irrigation would be adopted ; if it were greater, the danger of 
accidental loss would be borne. 



88 THEORY OF RISK AND INSURANCE [370 

A man in isolation, then, face to face with unequal degrees 
of risk involved in different ways of using his capital and labor, 
is restricted to three possible modes of conduct. He may 
avoid the uncertainty peculiar to a specific form of industrial 
activity by keeping out of the industry; he may reduce the 
degree of uncertainty by adopting devices that make the 
occurrence of the loss less probable ; or he may assume the 
risk and endure the attendant uncertainty. The first form of 
activity may be called avoidance of risk, the second, preven- 
tion, and the last, assumption. It is possible to combine the 
second and third methods by partially eliminating the risk 
through preventive measures and assuming the rest of it. The 
choice between different possible modes of action will be de- 
termined by a comparison of the disutilities involved in going 
without the product of the hazardous industry, in using the 
additional labor and capital necessary to reduce the risk, and 
in enduring the uncertainty incidental to the creation of the 
product. 

A man living in society has the same opportunity of mak- 
ing a selection between the three ways of meeting risk, and 
his choice is determined by a similar comparison of utilities 
and disutilities. These, however, are not of precisely the same 
nature as those which the man in isolation compares. The 
commodities created by different producers are not intended 
for the immediate satisfaction of the wants of those who create 
them ; they are produced for exchange. It is no longer pos- 
sible, therefore, for the person who produces a commodity to 
make a direct comparison between its utility to the consumer 
of it and the disutility involved in creating it. Confining our 
attention now to the risks incurred in the employment of cap- 
ital, let us see in what way the utilities in question are deter- 
mined. 

The choice between safe and unsafe investments turns on the 
relative risks and rates of interest in the two investments and 
on the unwillingness of the investor to incur risk. If the extra 



^^i] ^VAYS OF MEETING RISK 89 

return to be expected in the unsafe investment is large enough 
to offset the reluctance of the investor to incur the risk, he will 
choose that investment. He compares the utility of the prob- 
able increase in income with the disutility of the uncertainty. 

We have already noted that the reluctance to incur risk is 
not the same in all men. This fact has an important influence 
upon the assumption of risk in a catallactic society. Those 
who are most unwilling to take any chances naturally seek the 
safest investments, and those whose reluctance is least find 
their advantage in entering hazardous industries. The utility 
of the additional gain to be realized in such investments more 
than offsets for them the disutility of the uncertainty. If there 
were enough investors of all degrees of unwillingness, so that 
the unwillingness always varied inversely as the risk, the entire 
cost of inequalities in risk would be annihilated. But evidently 
such is not the case. There is a disproportionate amount of 
capital in safe investments. It is true, however, that on ac- 
count of this adaptation of investors to risks, the reward to be 
obtained for assuming risk does not always increase in pro- 
portion to the risk. The selection of the more hazardous 
investments by those who are least reluctant to assume risk 
reduces the net cost of risk to society. 

The choice between a safe and an unsafe investment, then, 
is determined by the subjective estimates put by the investor 
upon the utility of the increased income in the hazardous in- 
vestment and the disutility of the uncertainty. As the 
decision thus depends upon subjective factors, it is impos- 
sible to prophesy how any particular investor will act. The 
choice between different methods of carrying on an industry, 
that is, the question as to the adoption of any preventive 
measure, is determined in the first instance in much the same 
way. Comparison is made between the disutility involved in 
investing the additional capital necessary to introduce the 
preventive measure, and the disutility of the greater uncer- 
tainty if such a measure is not introduced. But here it is 



go THEORY or RISK AND lASURAXCE [3^72 

evident that the choice is not left entirely at the discretion of 
the investor. It is only when the interest on the capital 
required to introduce the preventive measure just equals the 
extra price necessary to bring about the assumption of the 
risk if the preventive measure is not introduced, that it is 
optional with an entrepreneur which method he shall adopt. 
If one method makes it possible to produce a commodity with 
less expense than the other involves, that method, in the 
absence of disturbing influences, will finally become universal. 
Therefore in the end it is by a comparison of the relative 
expenses that the choice between the different methods \\ill 
be determined. All preventive measures will be adopted that 
do not involve as much expense as would be incurred on 
account of the necessity of paying capital for the assumption 
of the risk that the measures are intended to annihilate. 

It is easy to see that in a dynamic society the possibility of 
realizing a profit by first using a preventive device that 
reduces expense is a great incentive to progress in the 
technique of production. It would be a mistake, however, to 
suppose that progress must always be in the direction of 
reducing risk. The reward for risk taking is only one 
element in the cost of production. If the adoption of a more 
uncertain method of creating a commodity made possible a 
considerable reduction in the amount of the capital and labor 
employed, it might cause the appearance of a profit. There 
would be less danger of destruction of property if the speed of 
trains were limited to ten miles an hour. The gain in other 
directions from the increased speed, however, more than 
counterbalances the effect of the greater uncertainty about the 
amount of loss. Whenever the additional expense caused by 
the increase in uncertainty is less than the saving due to the 
increased productivity of labor and capital, a profit may be 
realized by inaugurating the more uncertain method of pro- 
duction. 

A person living in a society where production is carried on 



373] WAYS OF MEETING RISK pj 

for the purpose of exchange, and where all sorts of personal 
relationships are established, is exposed to different risks from 
those which threaten a man in isolation. Some forms of static 
risk are reduced through the existence of society; others are 
greatly increased ; while all those connected with the rela- 
tions established between different men exist only in society. 
Special social institutions, such as the credit system, introduce 
many peculiar chances of loss and greatly increase the uncer- 
tainty of economic life. Dynamic risks are even more affected. 
A man living in isolation, producing solely for his own con- 
sumption, is not entirely free from risk of this kind. There 
may be a change in his disposition so that he ceases to care for 
a commodity of which he has accumulated a store; or he may 
make a discovery or an invention which renders useless a 
capital good that he has created. One who is producing 
commodities for exchange, however, is evidently subjected to 
far greater chances of dynamic loss. It may befall him on 
account of his failure to anticipate changes in the wants of dis- 
tant consumers ; or it may be due to an invention made by 
any one of a thousand competing producers. Another form 
of dynamic risk appears only in society, namely, uncertainty 
as to the action of governments on such questions as taxation, 
franchises, property rights, and the like. While, therefore, it 
is undoubtedly true that what may be called natural risk, un- 
certainty connected with the direct relations between man and 
nature, is much reduced by the development of a social state, 
society brings with itself a large class of distinctly social risks, 
resulting from the relations established between different 
human beings, which far exceed in number and variety the 
risks of the isolated state. 

On the other hand, society does much to assist the indi- 
vidual in warding off many forms of loss. Armies and navies, 
judges, magistrates, sheriffs, and policemen are supported 
largely for the purpose of preventing loss through violence or 
fraud. Information of various kinds is collected and dissem- 



92 THEORY OF RISK AND INSURANCE [374 

inated by the government to assist its citizens in forming cor- 
rect judgments as to the future movements of prices. There 
is a cordon of life-saving stations to lessen the dangers of the 
sea, and a weather bureau to give warning of the approach of 
unfavorable climatic conditions. Cities and towns support fire 
services to reduce the danger of conflagrations and to limit 
their destructiveness. Education is intended to increase 
honesty and carefulness as well as knowledge and ability. 

The state goes even further than this. It compels its citi- 
zens to do some things and to refrain from doing others, when 
such regulations are necessary to protect other persons from 
the chance of loss. A man having knowlege of an intended 
robbery must give warning to the proper authorities ; within 
specific limits no one is allowed to erect a wooden building ; 
the manufacture and storage of explosives in thickly settled 
communities is frequently restricted. In many ways the 
freedom of the citizen is limited for the purpose of warding off 
injury to the property of others. 

It is not alone through its official organs that society seeks 
to guard the security of its members. The same object is 
sought through voluntary associations of many varieties. 
There are combinations of manufacturers, wholesale dealers, 
retailers, real-estate owners, bankers, members of professions 
and of trades, inhabitants of sections of cities or of county dis- 
tricts, and countless others, that exist, wholly or in part, to 
protect those who belong to them from various kinds of loss. 
Finally, other forms of preventive activity are carried on by 
individuals for the purpose of private gain. A trade journal is 
partly supported by those who wish to reach correct judgments 
about existing industrial conditions by means of the informa- 
tion the paper contains, and thus lessen the danger of mistakes 
in the quantity and quality of the commodities they produce. 
The chief benefit of a mercantile agency is the protection 
it affords against the unwise extension of credit. The devel- 
opment of cheap and rapid means of communication has 



275] ff^A yS OF MEETING RISK g^ 

done much to reduce the amount of dynamic risk. On the 
one hand, it makes it possible to secure early information 
about industrial changes in distant places, and on the other 
hand, it enables a surplus of commodities in any limited 
area to be distributed throughout society. It has also led to 
the development of a special trade custom, which has reduced 
the dynamic risk connected with the production of many ar- 
ticles. To a great and increasing extent commodities are now 
manufactured "to order," and the danger of piling up large 
stocks for which no market can be obtained is thus avoided. 

These facts, and many others of a similar character which 
will occur to the reader, indicate the great importance that is 
attached to the prevention of accidental loss and the reduction 
of the amount of uncertainty. Every such device substitutes 
a definite expense of production for the chance of an indefinite 
loss. So far as the nature of the expense is concerned, it is a 
matter of indifference whether the preventive measure is carried 
out by individuals, by private associations, or by public bodies. 
Its distribution among these different agencies depends upon 
considerations of relative cost and efficiency. The question 
of the adoption of any such device is determined by a compar- 
ison of the relative costs of the device and of the uncertainty 
it is intended to annihilate. The statement sometimes made 
that as far as possible all accidental loss is prevented, is 
true only in a modified sense. It is easy to see that much 
more could be done to make such losses impossible. For 
instance, farmers might build their barns of fire-proof material, 
or burglary might be almost entirely prevented by a sufficient 
increase in the number of policemen. The correct statement 
would be that everything is done that can be done econom- 
ically. It would be poor economj^ for society, for the purpose 
of preventing accidental loss, to use up deliberately more cap- 
ital than would be destroyed by the event whose occurrence 
is dreaded. The tendency will be to adopt every preventive 
device which in the end yields a net gain to society; and the 



94 THEORY OF RISK AND INSURANCE [376 

practical test will be found in the comparative cost of pro- 
ducing the commodities by the more and the less uncertain 
methods. 

It may be worth while to consider whether the self interest 
of entrepreneurs can be relied upon to insure the adoption of 
all preventive measures which are economically desirable for 
society. It is evident that this is not the case when the meas- 
ure is one whose adoption has been made compulsory by law. 
If one builder could avoid expense by substituting a somewhat 
inflammable material for the fire-proof material that his neigh- 
bors and competitors are compelled to use, his risk of loss by 
fire would not be increased in proportion to the reduction in 
his expense. It is sometimes said, however, that there is a 
more fundamental opposition than this between public and 
private interests, and that it may at times be necessary ior 
society to compel the adoption of preventive measures which 
individual entrepreneurs would have no incentive for introduc- 
ing. Let us assume that an industry has been carried on 
under conditions that allowed a fluctuating amount of loss. 
The commodity produced in that industry will then be selling 
at a price which in a series of years will make good the loss 
to the group as a whole, and give each investor an extra 
reward on account of the risk he has been carrying. Let us 
suppose further that by the adoption of some preventive 
measure the average amount of accidental loss and the extent 
of the fluctuations could both be reduced. The improvement 
would evidently be adopted by individual entrepreneurs unless 
the expense of it was so great that the commodity could not 
be sold at as low a price as it was before. If it did involve an 
increase in price, would it under any circumstances be to the 
economic advantage of society to have it adopted ? It appears 
not. It is true that the improvement would prevent the 
accidental destruction of a certain amount of capital, and 
would also cut down the amount of the extra reward for risk- 
taking; but that saving could be accomplished only by the 



377] W-^KS" OF MEETING RISK gc 

deliberate destruction of a greater amount of capital to prevent 
the occurrence of the accidental loss. It appears clear, there- 
fore, that under conditions of free competition the adoption by 
individual entrepreneurs of any preventive measure that is for 
the economic advantage of society will be assured by the 
possibility of obtaining a profit as a result of introducing it/ 

We have been considering the social aspect of the three 
ways of meeting risk that are common to men in isolation and 
to those in society. We have called them respectively avoid- 
ance, prevention and assumption. We must now notice other 
courses of action, which are possible only in society. These 
are distribution, transfer and combination of risks. That these 
different methods of meeting risk are by no means mutually 
exclusive will be manifest as we proceed. We will consider 
each of them in turn. 

If ten men each put ^looo into a hazardous investment, the 
risk may be said to be distributed. If a loss occurs it will be 
partially borne by each of the ten men. We have already 
noted that under the influence of the law of diminishing utility 
an investor's reluctance to expose a given amount of capital to 
a definite risk decreases as his wealth increases. In general, 
we may say that the smaller the ratio is between the sum to 
be risked and the person's entire capital, the less is the reluc- 
tance to expose it to risk. If, then, the capital for a hazardous 
industry is made up of the marginal increments of the capital 
of many investors, the amount necessary to induce them to in- 
cur the risk will be less than the reward that would be nec- 
essary to induce a single investor in the same economic cir- 
cumstances to advance the entire amount. The superiority of 

^ In the absence of any system of insurance, legal compulsion may be j ustified 
in two classes of cases, namely: when the economic loss of the individual is liable 
to be accompanied by physical or mental injury to others, and when it is apt to 
cause loss of property by those who are unable to protect themselves. Laws pre 
scribing the use of fire-proof material in dwelling houses in thickly settled com- 
munities may be justified in either way. 



p6 THEORY OF RISK AiVD INSURANCE [378 

the corporate form of industry is partly clue to this fact.' It 
brings together the marginal increments of the capital of many 
investors. That it possesses many other great advantages 
goes without saying; but we are concerned only with its rela- 
tion to the assumption of risk. In a dynamic society it creates 
the possibility of making many industrial experiments which 
no individual investor would care to undertake. In a static 
society the prevalence of the corporate form of industry lowers 
the expense of producing commodities by reducing the reluc- 
tance to incur risk and the amount paid for its assumption. 
On account of the limited liability of the members of corpora- 
tions this gain is partially offset by an increase in the risk of 
those who become creditors of the corporation. On the other 
hand, the very limitation of liability greatly reduces the reluc- 
tance of the members of the corporation to incur risk. The 
net result is undoubtedly a very considerable gain to society 
in the form of a cheapening of commodities, made possible by 
the reduction in the amount paid to capital for assuming risk. 
A second method of distributing risk is the mutual 
guarantee against loss, sometimes entered into by a number of 
producers exposed to the same danger. This form of com- 
bination is too familiar to need any lengthy description. It is 
generally known as mutual insurance. In some cases the 
mutual guarantee is attended with the accumulation of a sur- 
plus, in others it is not. As the introduction of a surplus 
brings with it certain consequences which must be left for 
later consideration, we will for the present confine our atten- 
tion to the effect of the guarantee alone. By such a guarantee 
all the members of a combination pledge themselves to make 
good a loss of some specified kind which befalls any one of 
them. The payments of each member are determined partly 
by the amount of loss that actually occurs and partly by the 
value of the property insured by him. It is evident that, on 

'J. B. Clark, "Insurance and Business Profit," Quarterly Journal of Econom- 
ics, vol. vii, p. 52. 



379] WAYS OF MEETING RISK gy 

the assumption that the amount of positive loss is not affected 
by the existence of the combination, such an arrangement will 
reduce the cost of risk to society. There is a substitution of a 
large chance of a small loss each year for a small chance of 
a large loss. Now the unfavorable consequences of a loss 
increase out of proportion to the increase in the amount of 
the loss ; and therefore, while the amount of the probable loss 
for a series of years is not affected by a mutual guarantee, the 
reluctance of the producers to assume the chance of such loss 
is diminished. There will be, therefore, a reduction in the 
price of the products of the industries affected. It must be 
borne in mind that the gain realized by society through the 
devices that we are considering is not due to any diminution 
in the amount of capital actually destroyed, A mutual guar- 
antee against loss need not in any way affect the amount of 
positive loss. Whatever social gain is made is entirely due 
to the diminution of the negative loss which the existence of 
risk entails. Any device that lessens the unwillingness of men 
to incur risk brings the apportionment of capital nearer to the 
ideal static standard and thus increases its productivity. It is 
the increased product thus created that constitutes the social 
gain. 

There is another economic advantage in the mutual guar- 
antee against loss, which is due to the combination of a 
number of risks in a group and the consequent reduction of 
the degree of uncertainty for the group as a whole. This is 
the third of the social devices for meeting risk, the discussion 
of which must be postponed to the following chapter. We 
will now turn our attention to the second device, the transfer 
of risk. 

If one person guarantees another against possible accidental 
loss of any kind, there is a transfer of the risk of such loss 
from the latter person to the former. When the transaction 
takes place between persons who estimate risk alike, and who 
are equally reluctant to assume it, it will not occur without a 



q8 'I heory of risk and insurance [330 

simultaneous transfer of the reward to be obtained for carry- 
ing the risk. There would be no social gain in such an 
operation. If, however, the person who assumes the risk is 
for any reason less reluctant to do so than the one from whom 
it is transferred, the price paid for the transfer may be fixed 
somewhere between the reward demanded by the latter and 
the minimum amount which the former would require. There 
is an opportunity for both parties to the transaction to realize 
a net gain. The one to whom it is transferred obtains a 
reward for carrying it in excess of the amount that would be 
necessary to induce him to assume it ; and the one who trans- 
fers it purchases security at a price that does not take from 
him the entire net reward for risk-taking in the industry in 
which his capital is invested. Both of these gains are profits. 
The competition of the less reluctant risk-takers will gradu- 
ally cut down the price that can be obtained for assuming the 
risks to an amount that just compensates the marginal mem- 
ber of the group ; and on the other hand, if all investors in the 
hazardous enterprise can find risk-takers who will relieve 
them of uncertainty for a lower reward than they themselves 
demand, there will be an influx of capital into the industry 
which will sooner or later bring down the price of the product 
to the level that the reduced expense justifies. When the new 
adjustment has been reached, the productivity of capital will 
have been increased and society benefited. 

Now it is a matter of common observation that men differ 
greatly, both in their confidence in their own judgment about 
the chance of loss and in their willingness to assume chances 
that they estimate alike. There is in consequence a differen- 
tiation of the owners of capital into two classes according to 
their attitude towards risk. To the more enterprising class, 
anxious for industrial control, and willing to incur the inci- 
dental risks, President Hadley gives the name speculators,' 

' Arthur Twining Hadley, Economics, New York, 1896, p. 112. The influence 
of risk occupies so prominent a place in Prasident Hadley's discussion ofdistribu- 



28 1 ] WAYS OF MEETING RISK gg 

The others may in contrast be called investors. The class of 
investors embraces those capitalists who for any reason are 
chiefly concerned with obtaining a sure income, even if the 
amount of it is small ; the class of speculators consists of those 
who are so powerfully attracted by the possibility of securing 
la.ge gains, that they are willing to assume the chance of suf- 
fering accidental losses. Of course no hard-and-fast line can 
be drawn between the two classes. Degrees of risk and de- 
grees of unwillingness to incur risk increase from the lowest to 
the highest by infinitesimal increments. In a general way, how- 
ever, the two types of capitalists can be readily distinguished. 
Of the effect of this difference in character on the direct as- 

tion that it seems necessary to give his treatment of it special attention. It is not 
easy, however, to determine just what his position is. On the one hand, there is 
no separate discussion of the theory of risk, and on the other, it is sometimes dif- 
ficult to reconcile statements concerning risks, made in different connections. 
The entire net return to capital he calls gross profits. Their amount is determined 
in the following way: " The competition of capitalists with one another leads them 
to advance to the laborers a sum equal to the expected price of the product, less a 
compensation for waiting and the risks attendant upon it, sufficient to induce the 
proprietors to hazard the required amount of capital" (p. 300). Here gross 
profits seem to be regarded as reward for waiting and for risk-taking. Many of 
his statements, however, do not refer specifically to the waiting, and therefore 
seem, in form at least, to attribute gross profits to risk-taking alone. Thus on p. 
265: " In fact, they [capitalists] will not wish to go so far as this point [Cr]; for 
at Or they simply recover what they advance [to laborers in the form of wages], 
with no compensation for the risks which are always involved. To assume these 
risks they must have some adequate motive." Yet we find (p. 267) gross profits 
divided as follows: 

I " A payment for capita/ known as znieresL 

2. " A payment for location known as rent. 

3. " A payment for skillYnomn as net profit.^'' 

" The separation of interest from net profit or rent results in a separation of the 
reward for waiting from the rewards for risk and foresight" (p. 300). The last 
sentence seems to mean that interest is the reward for waiting, net profit for risk- 
taking, and rent for foresight. It is not easy to understand exactly how the same 
income can be at once reward for skill and reward for risk-taking. Skill and the 
assumption of risk are by no means universally correlated. But we are still further 
confused when we find from other passages that interest and rent are also affected 
by risk. As to interest : " This rate [of interest on what is considered absolutely 



100 THEORY OF RISK AND INSURANCE [382 

sumption of risk we have already spoken ; we are now con- 
cerned only with the system of transfer of risk which it makes 
possible. Venturesome capitalists are evidently the ones who 
will be most likely to assume exceptional risks. They may be 
attracted either by the exceptionally large reward for assum- 
ing risk, or by the hope of realizing a profit. They constitute 
the class of capitalist-entrepreneurs, whose peculiar relation to 
risk must now be considered.' It has already been shown 
that an entrepreneur with no capital of his own must pay for 
capital a price proportional to the risk to which it is to be ex- 
posed. Reward for risk-taking is no part of his income. On 
the other hand, a capitalist-entrepreneur who uses no capital 

good security] is not looked at by the individual as a payment for risk. Yet its 
height is probably in large measure a result of past experience as to losses" (p. 
280, note). As to rent: "Economic rent and net profit are like the producers' 
and consumers' surplus ... in being differential gains. . . . They are unlike 
them ... in being affected by differential losses which in some instances more 
than neutralize the gains. . . . But in point of fact, both rent and profits are of 
the nature of compensation for risk" (p. 288). It thus appears that all forms of in- 
come except wages are more or less "of the nature of compensation for risk." It 
is not thought possible, however, to correlate the income of the individual with the 
risk he runs. " Many of the writers who treat of the relation between business 
risk and business profit make the mistake of assuming that profits are an amount 
paid to the individual capitalist to cover his risk of loss. Far from it. They are paid 
to capitalists as a class for protecting the public against its risk of loss" (p. 288). 

One fact stands out clearly in all of President Hadley's references to " compen- 
sation for risk." The income to which he applies that term is not at all the same 
as that which we have identified as the special reward for assuming risk. What 
he has in mind is the chance gain of those capitalists who are so fortunate as to 
escape disaster. It is that sum which he connects with the skill of the investors, 
and which he is naturally unable to correlate with the amount of risk they run. 
Nowhere does he appear to recognize the existence of the net reward for assuming 
risk. As he definitely rejects productivity and sacrifice as determinants of the re- 
ward to capital, and as it is, so far as man's knowledge is concerned, uncertain 
which of two equally able and cautious investors will escape accidental loss of 
capital, it is evident that the influence of chance fills a very large place in Presi- 
dent Hadley's theory. 

1 J. B. Clark, " Insurance and Business Profit," Quarterly Journal of Econom- 
ics, vol. vii, p. 47, et seq. 



283] WAYS OF MEETING RISK lOi 

except his own will receive as his income the entire net prod- 
uct of the industry in excess of the amount paid for the labor 
he hires. It would be difficult to distinguish practically be- 
tween his interest, with the reward for assuming risk included, 
and his profit. There is a special complication, however, in 
those cases where the entrepreneur makes use both of his own 
capital and of borrowed capital in the same venture. It is the 
effect of this combination of capital that we are to consider. 

The relation between the capitalist-entrepreneur and the 
persons from whom he obtains his additional capital are 
affected by the following facts : The capitalist-entrepreneur 
generally has a large part of his capital invested in the in- 
dustry that he is managing, while his borrowed capital may 
consist of the marginal units of several investors. The desire 
of capitalists for a reasonable assurance of the safety of their 
capital leads them to limit the amount that they will lend to 
the capitalist-entrepreneur. The latter is generally personally 
liable for all loss and indebtedness, while the possible loss of 
the other investors cannot exceed their actual investment. 
Finally, it is seldom that an industrial venture results in total 
loss ; and in case of partial loss the capitalist-entrepreneur 
has to bear it all, unless it exceeds the total amount of his own 
capital. Under such conditions it is evident that, while all the 
capital is used in the same industry, it is not all exposed to the 
same degree of risk. The capitalist-entrepreneur has assumed 
practically all the risk. The other capitalists have made 
a transfer of the risk to which their capital would naturally 
have been exposed in the industry in question. Consequently 
they demand only a small reward in excess of pure interest for 
incurring the small risk which they still bear. While the de- 
gree of risk to which the industry as a whole is exposed re- 
mains unchanged, and the capitalist-entrepreneur may, there- 
fore, be able to obtain a large extra reward on account of the 
risk, he is obliged to hand over to the other capitalists little 
or none of this extra gain. It becomes a part of his own in- 
come. 



I02 THEORY OF RISK AND INSURANCE [384 

It is important to notice that this part of the capitaHst-en- 
trepreneur's income is not profit. It accrues to the capitalist, 
and not to the entrepreneur. Because the capital of the cap- 
italist-entrepreneur is exposed to a high degree of risk, it is 
able to obtain a high rate of reward. If the income were 
profit, it would be annihilated by the competition of other cap- 
italist-entrepreneurs. They would obtain capital on the same 
terms, and cut down the price of the commodity to the point 
where it would yield only so much extra income as it was 
necessary for them to pay to the other capitalists for the slight 
risk that the latter still ran. But capitalist-entrepreneurs will 
not act in that way. Their own capital is exposed to a high 
degree of risk, and they will not be willing to assume it with- 
out adequate reward. Their competition will reduce the price 
of the commodity only to the point where it yields them in 
addition to pure interest a net income that is just enough to 
reward them for assuming the risk. This income is deter- 
mined directly, just as pure interest is, and its amount is fixed 
by the reluctance of the capitalist-entrepreneurs to expose 
their capital to risk. 

As we have already stated, the transfer of risk does not 
necessarily reduce the degree of risk. The danger that ac- 
tually threatens the capital in an industry may be in no way 
afifected by the fact that the risk is disproportionally borne. 
At the same time, the cost of risk must be in some way re- 
duced by the transfer, if there is to be any social gain from the 
transaction. The capitalist-entrepreneur must be willing to 
bear the risk that is transferred to him by other capitalists for 
a smaller reward than they would demand, if they managed 
the business themselves. This greater readiness to enter a 
hazardous industry may be due to the hope of large gains from 
sources not open to the other capitalists, or it may be due to 
differences in personal character. In a dynamic society the 
former influence is frequently predominant. It is sometimes 
the possibility of realizing a large temporary profit from a 



385] WAYS OF MEETING RISK I03 

successful industrial venture, and not the amount of the reward 
for risk-taking, that makes the capitalist-entrepreneur willing 
to assume a high degree of risk for a small reward. In a static 
society, however, it is evident that any social gain that may be 
obtained through this form of organization must be due to 
differences in the character of different capitalists. On the 
one hand, those of a more venturesome disposition will be less 
reluctant to assume risk, and therefore will be found in the 
more exposed positions. On the other hand, if the capitalist- 
entrepreneur possesses, along with the venturesomeness, greater 
skill in calculating risk, and readiness in devising expedients 
for avoiding danger, than the other capitalists, the result of the 
transfer will be an actual reduction of the risk. Because the 
risk which the capitalist-entrepreneur assumes is less than 
that to which the other capitalists would be exposed if they 
were managing the business, the entrepreneur is willing to 
assume the risk of the industry for a smaller reward than the 
others would demand. The outcome will be a differentiation 
of capitalists according to their fitness for different kinds of 
service. Those who are especially reluctant to incur risk, and 
those who are poorly adapted to manage hazardous industries, 
will put their capital into positions of comparative safety; 
those who should occupy the exposed positions on account 
of their peculiar fitness for doing so, will assume the large 
risks incidental to the performance of the function of the 
capitalist-entrepreneur. Society will be benefited by the 
arrangement, as it is by all forms of division of labor that result 
in securing the right man for the right place. So far as the 
influence of risk is concerned, the gain will be measured by 
the reduction in the cost of commodities due to the actual 
diminution of the risk and to the lowering of the reward 
necessary to induce the assumption of risk. 

There is a point of special importance in connection with 
this peculiar income of the capitalist-entrepreneur that must 
not be left unmentioned. It is commonly said that according 



104 THEORY OF RISK AND INSURANCE [386 

to the productivity theory of distribution each unit of capital 
in a static state receives as its reward the part of the net prod- 
uct that is specifically imputable to it. It may be asked, then, 
in what sense the capital of the capitalist-entrepreneur is more 
productive than the rest of the capital in the same industry. 
It is evident that all the capital, after it has been put into an 
industry, contributes equally to the creation of the physical 
product. The capital of the entrepreneur, however, renders 
an additional service; it insures the capital of the other invest- 
ors. The answer to the question here raised, therefore, evi- 
dently depends on the answer to the more general question, in 
what sense capital is productive whose only service is the cre- 
ation of security. As it will be more convenient to consider 
that question in connection with the subject of insurance, we 
shall postpone our discussion of it to the following chapter. 

We have examined in the present chapter the three ways of 
meeting risk that are common to men in isolation and to men 
in society, calling them respectively avoidance, prevention and 
assumption. The attempt has been made to discover on what 
principle the choice between them would be determined by a 
man in isolation, and how the application of this principle is 
affected by the existence of society, and by a system of pro- 
duction for exchange. Two essentially social methods of 
meeting risk have also been considered. These are the dis- 
tribution of risk, realized by the corporate form of industry, 
and by the system of mutual guarantee against loss, and the 
transfer of risk, one form of which is seen in the capitalist- 
entrepreneur mode of organization. It remains to examine 
another device, which combines the two social methods already 
noticed and the third method, to which we have referred as the 
combination of risks. In the next chapter we shall discuss 
the economic significance of insurance in a static society. 



CHAPTER VII. 

INSURANCE. 

The term insurance has already been used in describing the 
fund accumulated to meet uncertain losses. It is evident that 
in a static state all producers who are exposed to risk must 
accumulate such funds. While it is uncertain whether the 
accumulation of any individual producer will be enough to 
meet the loss he suffers, that of the entire body of producers 
in any industry must be large enough to cover the losses of 
the group as a whole. Otherwise there would be in the long 
run a great diminution in the amount of capital in hazardous 
industries, and a serious disturbance of the static adjustment. 
Such a phenomenon is inconsistent with the notion of the 
static state. A fruit-dealer who at irregular intervals suffers 
loss through decay must add to the price of his fruit enough 
to cover such uncertain loss. A ship-owner has to increase 
his freight rates more or less, if his ships occasionally lie idle 
in port. In this sense, then, every producer, in the absence of 
all opportunity of transferring his risk, must insure himself. 
Such insurance would be defined as the accumulation of a 
fund to meet uncertain losses. From the point of view of 
economic theory, as has already been shown, the insurance 
fund includes only that part of the accumulation that is 
intended to cover the uncertain part of the loss ; it is that 
part only whose amount is affected by the influence of uncer- 
tainty. 

This individualistic method of providing for uncertain loss 
is spoken of* sometimes as latent insurance,' and sometimes as 

1 " Partout ou il y a un risque a courir, une assurance latente protdge la valeur 
3873 '°5 



I06 THEOKY OF RISK AND INSURANCE [088 

j-^^-insurance. Ttreia-tt-er term is usually applied to such con- 
duct on the part of large concerns with many risks of kinds 
commonly transferred to regular insurance companies; the 
former is more frequently used of the preparation to meet 
risks of kinds which insurance companies do not assume. 
While it may be impossible to avoid the use of the term insur- 
ance in referring to these forms of economic activity, it is evi- 
dent that in common usage the word is ordinarily employed 
in a different sense. It is used to denote the transfer of risk. 
Any person who guarantees another against accidental loss 
of any kind is said to insure him. It is in this sense that 
the capitalist-entrepreneur insures the capital of those from 
whom he borrows. This use of the term insurance, how- 
ever, like the preceding, fails to bring out its real signifi- 
cance. To apply it to all individualistic preparation for uncer- 
tain loss extends it too far in one direction ; to apply it to 
every transfer of risk extends it too far in another. To form a 
complete conception of insurance, it is necessary to add to the 
notions of accumulation of capital and transfer of risks the 
idea of the combination of the risks of many individuals in a 
group. We should define insurance, then, as that social 
device for making accumulations to meet uncertain losses of 
capital which is carried out through the transfer of the risks of 
many individuals to one person or to a group of persons. 
Wherever there is accumulation for uncertain losses, or wher- 
ever there is a transfer of risk, there is one element of insur- 
ance ; only where these are joined with the combination of 
risks in a group is the insurance complete. 

In many respects the increase in the number of distinct 
risks that an individual producer carries is analogous to the 
combination of the risks of many individuals. Other things 

ou meme le gain menac6 par ce risque. On la retrouve dans la commission 
prelev^e par le banquier, dans les prix surelev6s du marchand qui livre ^ credit, 
dans les taux parfois usuraires de certains prets." — Michel Lacombe, "Assurances," 
Say and Chailley's Nouveatt Dictionnaire a" Economic Politique, vol. i, p. loi. 



389] INSURANCE 107 

being equal, a ship-owner who has a hundred ships, and who 
carries his own insurance, is in the same economic condition 
as any one of a hundred ship-owners, each possessing one 
ship, who have combined their risks in a group through a sys- 
tem of insurance. The gain from the combination of risks is 
due solely to the increase in the number of risks in the group ; 
and if that increase takes place through the growth of a single 
industry, the same advantage is obtained. It is partly because 
of this fact that large industrial concerns are able to carry 
their own insurance. With the increase in the number of dis- 
tinct risks to which they are exposed, the cost of carrying the 
risk relatively diminishes. This gain is one of the influences 
that foster the growth of large industrial organizations. In 
the absence of all other conditions affecting their size, it would 
lead in the end to the concentration of each line of industry, or 
even of all lines, in the hands of a single organization ; and in 
the presence of these other conditions, the size that would 
finally be found most advantageous would be affected by the 
increase in the number of risks. 

It is time to point out the exact nature of the gain under 
consideration. It is evident that it will not be due to any 
reduction in the actual amount of positive loss. What the 
increase in the number of separate risks in the group does 
bring about is a reduction of the uncertainty for the group as 
a whole, a substitution of certain loss for uncertain loss. As 
was pointed out in the first chapter, the probable variation of 
the actual loss in any year from the average for a series of 
years increases only as the square root of the number of sep- 
arate chances of loss included in a group. Now, as we have 
seen, it is through the accumulation for meeting uncertain 
loss that the special reward for risk-taking is obtained. Com- 
petition will not cut the accumulation for this purpose down 
to the average amount of loss ; it leaves a margin of safety. 
It is evident, therefore, that anything that diminishes the 
degree of uncertainty reduces the cost of risk to society. As 



I08 THEORY OF RISK AND INSURANCE [3^0 

the uncertainty diminishes, the accumulation to meet the 
uncertain loss is brought nearer to the probable loss as esti- 
mated by the law of averages. If all the uncertainty could be 
annihilated, the accumulation would be limited to the exact 
amount of the foreseen loss, as in the case of any other fixed 
element in the cost of production. 

The application of this principle to the institution of insur- 
ance is evident at a glance. The risk that an insurance com- 
pany carries is far less than the sum of the risks of the 
insured,' and as the size of the company increases the dispro- 
portion becomes greater. It is primarily through this reduc- 
tion of uncertainty that a static society would be benefited by 
the existence of insurance. The cost of commodities would 
be reduced through the diminution of that part of the expense 
of producing them that is involved in the necessity of paying 
for the assumption of risk. The nature of this gain may be 
made clear by a simple illustration. 

Let us assume that there are 10,000 capitalists of the same 
reluctance to incur risk, each owning a house valued at 
;^5,ooo; that all the houses are exposed to the same danger of 
destruction by fire ; that the average annual loss for a period 
of years has been 50, and the average variation 20 ; and that 
the rate of interest in safe investments is 3 per cent. If each 
owner makes an allowance of 3 per cent, a year for the amor- 
tization fund, what annual rental will he demand for his 
house ? 

The uncertainty to which each investor is exposed is the 
resultant of two factors, the average loss and the probable va- 
riation. What would be the reluctance of an investor to incur 
the risk in the case assumed, and what reward would be nec- 
essary to overcome the reluctance, are empirical facts that we 

^ '< The aggregate danger is less than the sum of the individual dangers, for the 
reason that it is more certain, and that uncertainty of itself is an element of 
danger." William Roscher, Principles of Political Economy. Translated by 
J. J. Lalor. New York, 1878, vol. ii, p. 261. 



29 1] INSURANCE 109 

have no means of discovering. It is a conservative estimate that 
on account of the risk each capitalist will demand an extra one 
per cent, on his investment. The annual rent will then be at 
the rate of 7 per cent., that is, ^^350 for each house. At the end 
of a decade, if the favorable and unfavorable years just offset 
one another, the group will have suffered a loss of 500 houses, 
valued at ^$2, 500,000. This gives an average annual loss 
of ;^25 for each of the 10,000 investors. Meantime each of them 
has received ^50 a year on account of the risk. In the group 
as a whole the destroyed capital has been replaced, and each 
investor has received a net reward of ^25. The hirer of the 
house, who has had to pay this additional rent, is not at all 
concerned with the way in which the income has been dis- 
tributed among the different owners. Some of these have 
suffered losses which the ;^5o a year was not enough to cover; 
others have escaped loss, and the entire ;^50 represents a net 
gain for them. Each consumer, in this case each house- 
renter, has had to pay $2^ a year more than he would have 
had to pay if it had not been for the uncertainty. 

Now let us examine the situation of the same persons after a 
system of insurance has been introduced. We will leave out 
of consideration the incidental expense of the insurance itself, 
and for the sake of simplicity it will be assumed that the 
reluctance of the insurer to assume risk is the same as that of 
the house-owners, and that the fact that the houses are 
insured has no effect upon the probability of loss. What is 
the uncertainty to which the insurer is exposed when he is 
carrying the risk of the entire group, and what reward can he 
obtain for assuming it ? 

As the average variation of the annual loss has been 20, 
we may assume that a minimum loss of 25 houses for the ^^a 
group is certain to occur each year. The insurer, then, has to 
face a certain loss of 25 houses a year, and a probable loss, as 
determined by past experience, of 25 more. For the former, 
the competition of other insurers will prevent him from 



50 
09- 



I lo THEOR V OF RISK AND INSURANCE [392 

obtaining more than enough to replace the loss. That will be 
^125,000 for the group, or ;^ 12.50 for each house. For the 
uncertain loss we will assume that he will be able to obtain a 
return of twice the probable amount of loss, just as the single 
investor did, though there are reasons why he would probably 
demand rather less. That will make this part of his income 
^250,000 for the group, or $2^ for each house. Each house- 
owner, therefore, will have to pay the insurer ;^37.50 a year, 
and their competition with one another will prevent any one 
of them from obtaining more than that from the person to 
whom he lets the house. The entire rent will now be ;^337.50 
a year. Each consumer saves ;^ 12.50 a year, and each cap- 
italist is still rewarded at the same rate as before for carrying 
risk. If these 10,000 houses had been joined with a large 
number of others, so that there were, let us say, 1,000,000 in 
the group, a similar calculation would show that the cost of 
the risk to each hirer of a house would be reduced to $26.2^ 
per anmim, or only ^1.25 more than enough to cover the 
actual loss in a series of years. 

That this gain is in no way dependent on the combination 
of the risks of different investors in one group, and that it 
could equally well be obtained -by a single concern with an 
increasing number of risks is manifest. It is equally manifest 
that it would be advantageous for a person with a large num- 
ber of risks to join them with as many others of the same kind 
as possible. While so-called self-insurance becomes cheaper 
as the number of risks increases, it would never be as cheap as 
regular insurance if the insurance business were rightly man- 
aged. If it is cheaper for a concern to carry its own risk than 
to pay premiums to an insurance company, it shows either 
that the company considers the risk higher than the concern 
thinks is right, or that the insurance business is so expensively 
managed that the cost of the management more than offsets 
the gain from the increase in the number of risks. The prev- 
alence of the custom of self-insurance against risks such as the 



393] INSURANCE J I J 

regular insurance companies assume is a serious reflection on 
the management of the companies. 

The effect of the principle that we are considering on the 
size of insurance companies is the same as that already noted 
in speaking of independent industrial organizations. It is a 
force working towards large companies. The larger an insur- 
ance company is, the cheaper it can afford to give insurance. 
It might be impracticable, but it would not be economically 
unjustifiable, to require small companies to carry higher 
reserves in proportion to the amount insured than large com- 
panies are compelled to carry. In the absence of conflicting 
influences each branch of insurance would finally be concen- 
trated in the hands of a single company. Nor is there any 
reason why the process of centralization should stop here. 
There is the same economic advantage in combining risks of 
entirely different kinds, provided they are correctly estimated, 
as there is in combining risks of the same kind. The difficul- 
ties in the way of such general combinations are all of a prac- 
tical nature. Whatever may be said on the ground of expe- 
diency for the laws passed by some of our states restricting 
the freedom of insurance companies in the matter of assuming 
different kinds of risks, economic theory affords no justification 
for such a policy. The more risks the cheaper the insurance, 
is a universal economic principle. One enormous company ^ 
carrying all static risks would be the ideal organization of in- \ 
surance in the static state. 

The gain due to the combination of risks and to the conse- 
quent reduction of uncertainty is not the only economic benefit 
of insurance. There is another advantage resulting from the 
transfer of risk, which is of the same kind as the one pre- 
viously noticed in speaking of the capitalist-entrepreneur. It 
is desirable for society that risks should be correctly esti- 
mated. Men differ much in their ability to judge them. The 
segregation of the work of estimating risks leads to a differen- 
tiation of capitalists, as a result of which those who are 



1 1 2 THEOR V OF A'/SA' AND INSURANCE \l9A 

especially adapted to that task will be the ones who will 
undertake it. Moreover, their natural ability will be further 
developed through the experience and training of the work 
itself. On the other hand there are many men capable of ren- 
dering good service to society in comparatively safe industries, 
who are so constituted that the necessity of running any great 
chance of loss seriously diminishes their efficiency. The pos- 
sibility of transferring the risks of their business to others for 
a fixed premium frees them from the paralyzing influence of 
uncertainty, and enables them to make the best use of their 
powers in other directions. The gain to society from the 
transfer of risks is obtained partly through the reduction in the 
cost of carrying the risks when they are borne by those who 
have the most ability to estimate them and the most confi- 
dence in their own judgments about them, and partly through 
the increase in the efficiency of those who are abnormally sen- 
sitive to the influence of uncertainty. 

The gains of which we have been speaking are partly offset 
by the cost of carrying on the insurance business. This cost 
consists of interest on the capital and wages for the labor em- 
ployed in the actual performance of the work. What that cost 
ought to be, if insurance companies were economically con- 
ducted, and how far the actual cost exceeds that amount, we 
need not stop to inquire. There is a generous margin between 
the price for which a large insurance company can afford 
to assume a risk and the price which an individual producer 
would demand for carrying it. That this margin is not ex- 
hausted even by the extravagant methods of management 
that characterize existing insurance companies is proved 
by the almost universal prevalence of the custom of in- 
surance. That it is more nearly exhausted than it ought 
to be is proved by the persistence of the custom of self- 
insurance. It must not be forgotten, however, that in- 
surance companies carry on many other forms of activity 
besides their special work of furnishing insurance. Investment 



395] INSURANCE 113 

is a prominent feature of so-called life-insurance, and prevent- 
ive measures of various kinds are carried out by insurers of 
property. Insurers of boilers have their inspectors, fire insur- 
ance companies have their patrols, burglary insurance com- 
panies their private watchmen, and so on through the list. 
The part of the premium which is used in carrying out these 
protective measures ought not to be considered as part of the 
cost of insurance. It is work that would have to be done in 
some form by individual producers or by society, if it were 
not performed by the companies. The fact that the companies 
do it is an indication that it is accomplished more cheaply or 
more efficiently by them than it could be by the insured 
themselves. Another legitimate form of expense that ought 
to be recognized is the cost of securing the services of experts 
in appraising property and estimating risks. This work would 
also have to be performed in some way by individual pro- 
ducers if they carried their own risks. It might perhaps be 
accomplished more cheaply by them, but it would certainly be 
done more crudely and inaccurately. The gain from the 
accurate valuation of risks by experts more than counterbal- 
ances the necessary increase in the expense. 

There is another form of loss of serious proportions which 
must not be left unnoticed in comparing the advantages and 
disadvantages of insurance. It is an essential feature of a per- 
fect system of insurance that the occurrence of the event for 
whose economic consequences compensation is guaranteed 
shall never be a source of gain to the insured. In an ideally 
complete system the payment by the insurance company will 
just equal the loss of the insured. Now it is a matter of com- 
mon observation that insurance is often obtained in excess of 
the actual value of the property insured. As a consequence 
there is considerable wilful destruction of property for the 
purpose of obtaining the insurance. Moreover, it is doubtful 
whether it is practically desirable that the amount of the 
insurance equal the full value of the property, since no incen- 



114 THEORY OF RISK AND INSURANCE [3^6 

tive would be left to the insured to guard against the destruc 
tion of his property. Over-insurance leads to fraud, full 
insurance to carelessness, and even partial insurance to some 
diminution of watchfulness. Whatever increase may occur in 
the amount of positive loss either through fraud or through 
carelessness must be deducted from the diminution in negative 
loss in estimating the net gain which insurance brings to 
society. 

The economic significance of insurance in a static state is 
connected with its influence in reducing the burden which the 
existence of risk imposes on society. So far as the degree of 
risk is lowered, and the reluctance to assume it is diminished, 
so far is society benefited by the institution of insurance. How 
great the gain is, even under existing imperfect conditions, it 
is impossible to estimate, since it is difficult to conceive how 
the large enterprises of the present day could be carried on 
without the possibility of transferring to insurance companies 
many of the risks involved in them. It could certainly be 
done only on a much larger margin of safety than is now con- 
sidered necessary. 

The essential features of economic insurance as we have de- 
fined it are the accumulation of capital to meet uncertain losses, 
and the transfer and combination of risks. Many other con- 
ceptions of insurance have been held by various writers on the 
subject. Some originated in an over-emphasis of a compara- 
tively unimportant phase of the institution, others in a wrong 
interpretation of some feature of it. As an example of the 
former kind may be mentioned the conception of those writers 
who find the significance of insurance in the diffusion of pos- 
itive losses over a large group of persons.' That the insured 

1 Consideree dans son principe meme, I'assurance est une association qui a pour 
objet de repartir entre tous ses membres les pertes occasionndes ^ quelques-uns 
d'entre eux par certains 6v6nements fortuits, de telle sorte que chaque membre 
supporte sa part de I'indemnitd due aux victim es du sinistre." — Ch. Dumaine, 
'Assurances," Say's Dictionnaire des Finances, vol. i., p. 220. 

" Versicherung im wirtkschaftlichen Sinne ist diejenige wirthschaftliche Ein- 



397] \ INSURANCE 115 

in the long run pay all the losses is undoubtedly true, but the 
distribution of the losses is only an indirect result of the insur- 
ance ; it is neither the purpose of it nor the immediate conse- 
quence. Tlie4HiJ:pas£of_secui^^ 

tainty;;___The insured buys security by the payment of a fixed 
premium, and after he has bought it his condition is not affected 
by the number of losses which the insurer may have to make 
good. If the number of losses increases, the premium rate may 
be raised ; but in all cases of complete insurance the cost of it is 
a definite element in the expense of production, the amount of 
which is fixed before the occurrence of the losses. Only in 
the case of mutual assessment companies is there a direct dis- 
tribution of losses over a group. A member of such a com- 
pany is not in the same economic situation as one insured for 
a fixed premium. He has not transferred his risk and pur- 
chased security ; he has exchanged one risk for another, usu- 
ally a small chance of a large loss for a larger chance of a 
smaller loss. Where there is a mere diffusion of loss there 
remains some degree of uncertainty as to the amount of loss 
that each member of the group will suffer ; where there is 
complete insurance the insurer has taken upon himself the 
entire chance of loss, so far as concerns the risks covered by 
the insurance. To define insurance, then, as the distribution 
of losses is to make too prominent an indirect and compara- 
tively unimportant result of it, and to leave entirely out of the 
definition the elements in which its economic significance 
really lies. 

The other erroneous conception of insurance to which refer- 
ence has been made is even more indefensible than the one 

richtung, welche die nachtheiligen Folgen (zukiinftigen) einzelner, fiir den Betrof- 
fenen zufdlliger, daher auch im einzelnen Falle ihres Eintretens unvorhergesehener 
Ereignisse fiir das Vermogen einer Person dadurch beseitigt oder wenigstens ver- 
mindert dass sie dieselben auf eine Reihe von Fallen vertheilt, in denen die 
gleiche Gefahr droht, aber nicht wirklich eintritt." — Adolph Wagner, " Versicher- 
ungswesen," Schonberg's Handbuch, 4te Auf, 2 Band 2, s. 359. 



11 6 THEORY OF RISK AND INSURANCE [^gg 

just noticed. Instead of arising from an over-emphasis of a 
comparatively unimportant feature of the institution, it is based 
on an essentially false idea of its nature. Because each insur- 
ance contract considered by itself is a contingent contract, and 
because the event upon which the payment by the insurer to 
the insured depends is uncertain, many writers have regarded 
insurance as a form of gambling.' But the resemblance is in 
reality of the most superficial kind. It is not difficult to dis- 
cover the mark of distinction between the two transactions. 
Insurance involves the transfer of an existing risk from one 
person to another ; gambling involves the creation of a new 
risk to which neither party to the transaction was exposed 
before the contract, and to which they are both exposed after 
it. If a man insures his factory, he frees himself from uncer- 
tainty, and the other party to the contract assumes it; if he 
makes a wager with another, his own uncertainty and that of 
the other person are both increased at the same time. Un- 
doubtedly in the past many transactions which wore the 
virtuous guise of insurance were no better than gambling con- 
tracts. If a person takes out a policy on property in which he 
has no insurable interest, he virtually makes a wager with the 

1 " Let us now contrast the workings of insurance. In this case also the con- 
tract is a wager. A house-owner pays an insurance company fifty dollars, in re- 
turn for which he is to receive five thousand dollars in case his house burns down 
within a specified time ; just as he might pay a book-maker fifty dollars and re- 
ceive five thousand in case a specified horse wins a race." — Arthur T. Hadley^ 
Economics, p. 99. 

" Le contrat al6atoire est une convention r^ciproque dont les eff5ts, quant aux 
avantages et aux pertes soit pour toutes les parties, soit pour I'une ou plusieurs 
d'entre elles, dependent d'un 6venement incertain. Telles sont le contrat d'as- 
surance, . . . le jeu et le pari, . . ." — Code civil francjais. Art. 1984. Quoted in 
Charles Berdez, Les Bases de V Assurance Privke, p. 36, note. 

" Wenn also der unorganisierte Spiel des Schicksals den Menschen in Gefahr 
bringt, so begreifen wir, dass das Mittel, welches er ihm entgegensetzt, ein or- 
ganisiertes GlUckspiel sein wird. Er erreicht dadurch die Wirkung, dass er zur 
selben Zeit, wo er von eineme Verlust betroffen wird, durch das GlUckspiel einen 
Gewinn erhalt, der gerade den Schaden deckt." — R. Schlink, Die Natur der 
Versicherung, WUrzburg, 1887,5. 13. 



399] INSURANCE 117 

insurance company that the property will be destroyed. Such 
contracts are clearly against public policy, and legislation has 
done much to limit their number. The courts on the other 
hand have frequently given a liberal construction to the phrase 
" insurable interest," and many contracts of doubtful legitimacy 
are still tolerated. A legitimate insurance contract, however, 
may always be distinguished from a gambling contract by the 
principle pointed out. Insurance is the transfer of risk, gam- 
bling the creation of risk. 

After a system of insurance against any class of risks has \ 
been established, an entrepreneur has a choice between 
three methods of meeting such a risk in an industry that he 
has decided to enter. He may adopt preventive measures, he 
may obtain insurance, or he may carry the risk and pay a 
higher price for the capital he borrows. His selection among 
these different modes of conduct will depend upon their rela- 
tive cost. Expenditure for any one of them is to him an item 
in the cost of production, and he will naturally adopt the one 
that is cheapest. As a matter of fact, in nearly all cases it is 
necessary to combine the three methods. Preventive measures 
are adopted by which the total amount of risk is somewhat 
reduced; a part of the remaining risk is transferred to insur- 
ance companies ; the rest is borne by the capital in the indus- 
try. The amount of the expenditure for each of these pur- 
poses is determined according to the principles already 
established. The payment for the capital exposed to risk 
contains an element of reward for risk-taking, which is large 
in proportion to the degree of risk ; the payment for insurance 
contains a relatively smaller element of the same kind; the 
payment for prevention contains none at all. 

The entire sum paid by the insured to the insurance com- 
pany is called the insurance premium. As the companies 
carry on many forms of activity which are not an essential 
part of their business of furnishing insurance, and the expense 
of which is paid out of the premiums they receive, the cost of 



Il8 THEORY OF RISK AND INSURANCE [40O 

the insurance itself is less than the amount of the premium. 
In a strict economic sense the insurance premium includes 
only that part of the payment to the company that would 
have to be made to induce it to assume the risk. Expendi- 
tures for preventive measures, M^hether made directly by the 
entrepreneur himself, or first incurred by the insurance com- 
pany and then recovered from the insured, are no part of the 
cost of insurance. This distinction, however, is not observed 
by all writers.^ Because the entrepreneur has a choice be- 
tween prevention and insurance, it seems to be inferred that the 
two forms of expenditure are essentially alike. It is evident, 
however, that if all expenditures for the purpose of preventing 
accidental loss are to be regarded as insurance premiums, a 
very considerable part of the cost of production must come 
under that head. Such an extension of the term insurance 
utterly destroys its economic significance. Nor is the situa- 
tion much improved by limiting its application to the expendi- 
tures for those preventive measures that make it possible to 
obtain insurance from organized companies at a lower rate. 
The distinction does not depend on any such accidental cir- 
cumstance as that. It goes back to the fundamental difference 
between the methods by which the amounts of the two kinds 
of payments are determined. One includes an element of 
reward for risk-taking, which in the case of insurance goes to 
the insurer, whose capital is bearing the risk ; the other is 
determined by the direct cost of introducing the preventive 
measure, whether the work is done by the entrepreneur him- 
self or by the company. Prevention and insurance are com- 
plementary methods of preparing to meet uncertain losses ; 

1 See, for example, Alfred Marshall, Principles of Economics, vol. i, p. 469, 
note. " Again, certain insurance companies in America take risks against fire in 
factories at very much less than the ordinary rates, on condition that some pre- 
scribed precautions are taken, such as providing automatic sprinklers, and making 
the walls and floors solid. The expense incurred in these arrangements is really 
an insurance premium, . . ." 



40l] INSURANCE Hq 

only confusion can result from the attempt to make them 
identical. 

Not only do insurance companies carry on many forms of 
activity that are no part of their peculiar functions as insurers, 
but not all their activity as insurers has any direct bearing 
on the productivity of capital. The insurance of consump- 
tion goods is almost as common as the insurance of capital 
goods. It would not be difficult, in the light of the principles 
already discussed, to discover the laws that determine the 
adoption of insurance by the owners of consumption goods, or 
the nature of the social service that such insurance renders. 
A study of that sort would not be without interest, but it is 
outside the range of our investigation. We are concerned 
only with the insurance of capital, that is, with insurance as a 
method of lowering the cost of producing commodities. 

Insurance is primarily a method of making accumulations 
to meet uncertain losses. Attention has already been called to 
the gain that accrues to society through the reduction in the 
amount of such accumulations which insurance brings about. 
There are one or two other points in connection with this 
aspect of the institution that deserve consideration. Capital 
alone can insure capital. The guarantee of security by one 
who had no means of making good the losses that occurred 
would be a fruitless proceeding. The amount of capital neces- 
sary to give security evidently depends on the amount of risk 
that the capital assumes. As the number of risks carried by 
an insurance company increases, the amount of its accumula- 
tions also must increase. Stock companies start with a cer- 
tain amount of capital contributed by the members of the 
company, and make additional accumulations out of the con- 
tributions of the insured. Mutual companies, if they are to 
perform their functions perfectly, must also make accumula- 
tions of the same kind, but these funds are all contributed by 
the insured themselves, who virtually constitute the company. 
From the point of view of economic theory the difference 



120 THEORY OF RISK AND INSURANCE [402 

between the two kinds of companies is of no significance. 
One form of insurance is not necessarily any cheaper than the 
other. If the entire business of insurance were on a strictly 
competitive basis, and if the accumulation of the companies 
were in all cases limited to the amounts necessary to give 
security, it would be a matter of no importance by whom the 
funds were contributed. Capital is invested in the business of 
insurance for the same purpose that any other investment is 
made — in order to obtain a reward. If the insuring fund of 
the mutual companies is made up out of the current contribu- 
tions of the insured, the owners of the capital thus invested 
will require in some form the same return on their capital that 
they could obtain in any other investment with the same de- 
gree of risk. The members of the mutual company are carry- 
ing on the business of insurance with a part of their capital, 
which acts as a guarantee fund for the capital that they have 
invested in more hazardous enterprises. The gain accrues to 
the insured as insurers instead of accruing to the members of a 
stock company. As there is no reason why the accumulations 
of mutual companies should be any less than the accumula- 
tions of stock companies, of which the capital stock forms apart, 
there is no reason why the return to the capital thus invested 
should be any less in the former than in the latter. Whatever 
gain can be secured under competitive conditions by insuring 
in a mutual company rather than in a stock company is due 
to the fact that the insured themselves have invested capital in 
the insurance business. 

How large the accumulations of insurance companies ought 
to be in proportion to the risks they carry, can be determined 
only by experience. The prime requisite of such an institu- 
tion is security. Therefore the accumulations must be large 
enough to cover the probable losses, with a margin of safety 
for unexpectedly large ones. It is safe to say, however, that 
the accumulations of many companies are in excess of the 
amount thus determined. I do not refer here to the accumu- 



403] INSURANCE 121 

lations made by life insurance companies, which combine 
entirely different functions with that of insurance, and a large 
part of whose funds represent simply investments of capital by 
the insured. Nor do I include that part of the funds of insur- 
ance companies which is used for other purposes than insur- 
ance, such as the expenditures for preventive measures. That 
part of their accumulations which is strictly an insurance fund 
is often larger than it needs to be. The possibility of making 
such unnecessarily large accumulations is due to imperfect 
competition, which does not force the cost of insurance down 
to the competitive level. If, however, it were necessary for 
these funds to lie idle in the vaults of the company, it is evi- 
dent that there would be no motive for making accumula- 
tions larger than the conditions of the business demanded. 
Any excess would be distributed as dividends among the 
stockholders of the company, or, in a mutual company, 
would result in an immediate lowering of the insurance pre- 
mium. That this distribution of the entire surplus does not 
take place is explained by the fact that capital which is insur- 
ing the other capital is not prevented on that ground from 
participating in other forms of industrial activity. We have 
already seen in the case of the capitalist-entrepreneur that 
while his own capital acts as a guarantee fund for the capital 
that he borrows, it at the same time performs its part in the 
direct productive activity of the industry in which it is invested. 
The fulfilment of the insurance contract does not require the 
creation of new capital; it requires merely the transfer of the 
ownership of existing capital. Therefore the accumulated 
funds of insurance companies, even that part of them which is 
economically necessary, instead of remaining otherwise unpro- 
ductive, are invested in such ways that they earn an income 
for the company. Of course there are certain restrictions as 
to the forms in which such investments should be made- 
For practical reasons it is desirable that the funds should be 
invested where there is the least danger of loss, and where the 



V 



1 2 2 THE OR Y OF RISK A ND INS URA NCR [404 

difficulty 01 realizing on the investments is at a minimum. 
But the important point is that capital which is insuring other 
capital may at the same time be directly employed in the pro- 
duction of wealth. The unnecessarily large surpluses of 
insurance companies are allowed to accumulate, not for the 
sake of the reward they can obtain in the insurance business, 
but for the sake of the interest paid for their use by those to 
whom they are lent. 

It is evident that the possibility of using productively the 
reserve funds of insurance companies reduces the cost of 
insurance. Under competitive conditions the return that cap- 
ital invested in the insurance business can secure will be fixed. 
In the long run it will consist of pure interest plus the reward 
for carrying the risk to which it is exposed. All other income 
that the companies receive will operate to reduce the payments 
of the insured. If it were necessary for reserve funds to remain 
unproductive, the income that they now earn would have to 
be obtained from the insured in the form of higher premiums. 

One question in this connection remains to be answered. 
In what sense is the employment of capital to insure other 
capital a productive function ? The difficulty in answering 
this question is due to two circumstances. On the one hand, 
capital which is insuring other capital may at the same time 
be productively employed in other ways and create the same 
amount of physical product as any other capital so employed. 
On the other hand, the reward which capital obtains for insur- 
ing other capital is entirely created by the capital that is 
insured. It is evident, therefore, that insuring capital, as 
such, is not directly creating physical product. Its service is 
to create a condition which increases the productivity of the 
capital that is insured. In return for this service a part of the 
product of the insured capital is handed over to the insurer. 
But this is not to deny the productivity of the insuring capi- 
tal. In an economic sense the product of a unit of capital is 
the part of the total product whose creation is due to the pres- 



405] INSURANCE ,* 123 

ence of that particular unit. If, then, the insuring capital, by 
virtue of its service in guaranteeing safety, increases the total 
product of the insured capital, the additional part must be 
attributed to the insuring capital as its product. If there were 
a monopoly of the privilege of granting insurance, the entire 
increase in product might be appropriated by the insurers. 
Perfect competition, on the other hand, would bring about an 
influx of capital into the insuring business which in the end 
would reduce the total return to capital in it to the same pro- 
portions as the return to capital in any other industry involving 
the same degree of risk. The remainder of the economic gain 
due to the existence of the institution of insurance would then 
accrue chiefly to the consumers of the commodities created in 
the industries in which the insured capital is employed. There 
is no fundamental difference in kind between the reward for 
risk-taking which accrues to capital employed directly in a 
hazardous enterprise and the reward which insuring capital ob- 
tains for the risk it assumes. In both cases there is an increased 
productivity of industry on account of the assumption of the 
risk, and in both cases the capital exposed to risk obtains a 
part of the increased product as its special reward. In both 
cases, moreover, the amount of the extra reward which capital 
can obtain by assuming risk is fixed by the sacrifice of the 
most reluctant investor whose capital is needed to meet the 
demands of society. The only difference between the two 
kinds of income is the comparatively unimportant one that in 
the former case the extra product is created directly by the 
capital that receives it, while in the latter case it is created by 
other capital and handed over to the insuring capital as a 
reward for creating the conditions which make possible the 
increased productivity of the capital which is insured. 

The statement is sometimes made that all insurance is 
mutual insurance.^ It is evident from a consideration of the 

1 See, for example, H. C. Emery, " The Place of the Speculator in the Theory 
of Distribution," Publications of the American Economic Association, 3d Series, 
vol. i, no. I, p. 105. 



124 THEORY OF RISK AND INSURANCE [406 

facts already established that this is only partially true. All 
insurance is mutual in the sense that all the losses are in the 
long run paid by the insured. Obviously an insurance com- 
pany could not long survive if it systematically made good the 
losses of the insured out of its own capital. To the company 
the payment of losses is an element in the cost of carrying on 
its business, and in the long run consumers necessarily pay 
all the expenses of production. This mutual aspect of insur- 
ance, however, does not bring out its fundamental significance. 
This lies in the reduction of the cost of producing commod- 
ities through the relief of producers from the disagreeable 
feelings aroused by uncertainty, and the substitution of security 
for insecurity. The burden of insecurity which would rest 
upon individual producers in the absence of a system of insur- 
ance is in no way borne by the insured as a body after insur- 
ance has been introduced. A large part of it is entirely 
annihilated, and the remainder rests upon the insurers whose 
capital has assumed the risks of the insured. Even in the 
case of so-called mutual companies, while the surviving uncer- 
tainty is still borne by the members of the company, the real 
significance of the institution does not lie in this fact, but in 
the reduction of the uncertainty as a result of the insurance. 
The over-emphasis of its importance in causing a diffusion of 
loss is due to an imperfect analysis of its economic effects. 

Insurance is evidently far from being a gratuitous gift to 
society. The component parts of its cost are the wages of the 
labor employed in the insurance business, interest on the cap- 
ital invested in it, and any increase in the amount of positive 
loss through fraud or carelessness, which the existence of 
insurance induces. This cost first falls upon the entrepreneurs 
who choose to insure their capital rather than to pay capital- 
ists a higher price on account of risk. To the entrepreneurs, 
therefore, it is a part of the cost of production ; it will be em- 
bodied in the price of the commodities, and will thus be shifted 
to the shoulders of consumers. It is in the end the consum- 



40/] INSURANCE I25 

ing public that pays the entire expense of insurance. This 
does not by any means imply that the condition of consumers 
is not benefited by the existence of insurance. The compari- 
son lies, not between the cost of insurance and no cost, but 
between the cost of insurance and the cost of risk without 
insurance. The gain to the consumer comes through the 
reduction in the price of commodities, and the amount of the 
reduction is determined by the difference between the interest 
which the entrepreneur would have to pay for capital exposed 
to the entire risk of the industry on the one hand, and the lower 
interest on the capital when it is insured, plus the cost of the/ 
insurance itself on the other hand. *— ^/ 

There has been a singular lack of unanimity among writers 
on political economy with regard to the division of economic 
theory in which the treatment of insurance ought to be 
placed. Some have considered it in connection with pro- 
duction, others have regarded it as a phenomenon of con- 
sumption, while still others have found it inexpedient to bring 
it under any of the recognized divisions, and have put it 
at the end of their works along with other subjects of a more 
or less dubious economic character. There seems to be little 
occasion for such uncertainty. If the old divisions of produc- 
tion, distribution, exchange and consumption are to be main- 
tained, there is no doubt that the proper place for the discus- 
sion of insurance, at least so far as insurance of capital is 
concerned, is in the department of production. With regard 
to the insurance of consumption goods the case may not seem 
so plain at first sight, since there is not the same direct rela- 
tion between such insurance and the productivity of industry. 
Nevertheless, it undoubtedly belongs in the division of pro- 
duction. It belongs there, not because it affects the produc- 
tivity of other capital, but because the creation of security is 
in itself a form of production. If the owners of consumption 
goods are willing to pay a price for the sake of having them 
nsured, it is evident that they are obtaining something in ex- 



126 THEORY OF RISK AND INSURANCE [408 

change which is of more value to them than the money with 
which they part. What they obtain is security, and whether 
or not it seems best to consider such security as a consump- 
tion good, or as any form of wealth, it cannot be questioned 
that the capital and labor engaged in creating it are serving 
mankind in the same way as that employed in the creation of 
any commodity for which consumers are willing to pay. 

The conclusions reached in the present chapter are in part 
as follows : Complete insurance, in the economic sense, is the 
accumulation of funds for uncertain losses and the combina- 
tion of the risks of individuals in a group. The advantage of 
such an institution in a static society would be the result of 
its influence in reducing the burden of risk. To call all insur- 
ance mutual, or to define it as the distribution of losses, is to 
put the emphasis on a comparatively unimportant aspect of 
it ; to call it gambling is to confuse forms of activity funda- 
mentally different both in their purpose and in their conse- 
quences. Capital employed in insuring other capital is pro- 
ductive, and the reward it receives is a part of its product. 
Capital employed in insuring consumption goods is creating 
something for which the owners of the goods are willing to 
pay. It, therefore, is also productive. The treatment of 
insurance naturally belongs in the division of economic theory 
that deals with the phenomena of the production of wealth. 



CHAPTER VIII 

CONCLUSION 

Before attempting to give a summary of the static theory 
of risk and insurance developed in previous chapters, it may 
be worth while to consider briefly one or two special phases 
of the influence of risk in a dynamic society. No attempt 
will be made to work out a complete dynamic theory. Static 
laws are comparatively easy to discover, since the economic 
forces at work in a static society are by hypothesis few and 
simple. In a dynamic society the conditions are very differ- 
ent. Dynamic changes are continually introducing disturb- 
ances into the economic system. The new forces modify the 
action of the static forces, sometimes reinforcing them and 
sometimes opposing them, and the simplicity of the static state 
is replaced by the apparent irregularity and confusion of the 
existing industrial world. That this irregularity is only appar- 
ent, and that with the progress of economic science general 
principles will be discovered by which the movements of a 
dynamic society can be classified and traced to their sources, 
is undoubtedly true. It is in this field that the most difficult 
and most important work of economic theory remains to be 
done. It will naturally be divided into two parts. One will 
deal with the laws governing the dynamic changes themselves, 
and the other will trace the working of the laws of the static 
state under dynamic conditions. It is in the second of these 
divisions that the following brief discussions would fall. The 
most that will be attempted is to point out the bearing of the 
static laws of risk already discovered on certain dynamic prob- 
lems. We shall take up only these three questions : the in- 
409] 127 



128 THEORY OF RISK AND INSURANCE [410 

fluence of risk upon the accumulation of capital, the relation 
of the entrepreneur to developmental risks, and the economic 
character of the service of the speculator as insurer. 

Risk retards the rate of accumulation of capital. Every 
increase in the amount of capital, other things being equal, 
diminishes the productivity and reward of each unit of it. On 
the other hand, every additional unit of capital saved, other 
things being equal, involves an increased sacrifice on the part 
of the person saving it. Saving is carried by each individual to 
the point when the sacrifice and the reward offset each other, 
and then it ceases. Now the necessity of exposing capital to 
risk increases the sacrifice involved in saving. Saving ceases 
while the marginal productivity of capital is still high enough 
to reward the risk-taking as well as the abstinence. If the 
degree of risk were uniform in all investments, it is evident 
that the extent of the influence in this direction would depend 
entirely upon this uniform degree of risk. With unequal de- 
grees of risk, the relation between the risk and the accumula- 
tion of capital is not quite so simple. The effect of the risk 
is determined immediately by the relation between the risk 
and the reward in safe investments. But the rate of interest 
here is itself affected by the risk in other investments. We 
have seen how the requirement by capitalists of an abnormally 
high reward in hazardous industries reduces the return in safe 
industries below the normal level. When the risk in different 
investments is unequal, therefore, its influence in retarding 
accumulation is much greater than would be inferred from 
the degree of risk in those which are safest. In order to de- 
termine what that influence is, it would be necessary to calcu- 
late some sort of an average of the risks in all investments. 
It is possible that this might be taken at a point where greater 
and smaller risks are so balanced that the productivity of 
capital is not affected by the inequality in the degrees of 
risk. The reward necessary to overcome the reluctance to 
incur this average degree of risk determines the margin of 
saving. 



4 1 1] CONCL USION 1 2Q 

As risk retards the accumulation of capital, anything that 
reduces the degree of risk or the reluctance to assume it pro- 
motes accumulation. Insurance in a dynamic society may be 
regarded as a method of fostering the growth of capital. The 
gain in question is not at all the one on which enthusiastic 
life insurance agents lay so much stress. Whatever may be 
the advantage of so-called life and endowment insurance as 
forms of investment, furnishing opportunity for investment is 
no part of the insuring function. 

The advantage to which we refer is of a more fundamental 
character. It is due to the influence of insurance in extending 
the range of safe investments. There are large amounts of 
capital, such as trust funds, savings-bank deposits, and even 
the reserves of the insurance companies thenlselves, in the 
investment of which safety is the prime consideration. This 
fact tends to reduce the rate of interest in safe investments to 
a very low point. Every increase in the opportunity for mak- 
ing such investments has an influence in retarding the fall of 
the rate of interest in them, and so in pushing further out the 
point of equilibrium between the sacrifice and the reward of 
saving. 

One other point in connection with the influence of risk on 
the accumulation of capital deserves to be noticed. Just as 
the sacrifice of abstinence diminishes, other things being equal, 
as a man's income increases, so the sacrifice of risk-taking 
becomes less as his capital becomes greater. The result is a 
tendency towards a more and more unequal distribution of 
capital. The sacrifice of a laboring man in saving a hundred 
dollars from his year's income is apt to be very great. There 
is, therefore, need of a large reward to make him willing to 
undergo the sacrifice. And just because it costs so much to 
accumulate the capital, he feels great reluctance to expose it 
to the chance of loss. Safety is to him a matter of the first 
importance. In the use which he makes of his capital, there- 
fore, he is confined to the least hazardous investments ; and 



1 30 THEOR Y OF RISK AND INSURANCE [4 1 2 

in these investments the rate of interest is near the mini- 
mum. Those who need the largest reward to make them 
wilHng to save are the ones who can obtain only the smallest 
reward on account of their unwillingness to incur risk.^ By- 
far the larger part of the savings of society come out of the 
incomes of large capitalists and entrepreneurs ; the contribu- 
tions of laborers and small capitalists are comparatively insig- 
nificant. Now the increase of capital is in itself almost an 
unmixed good. Moreover, there are certain advantages in its 
unequal distribution. The total saving of society is thereby 
increased, and the existing capital is more productively em- 
ployed. The growth of large fortunes in recent years has 
done much to extend the margin of industry into the territory 
of hazardous enterprises. Even the small capitalists are indi- 
rectly benefited thereby, through the drawing off of capital 
from safe investments and the retardation in the fall of the rate 
of interest in them. But it is possible to pay too high a price 
for the gain thus realized. The accumulation of capital is not an 
end in itself, nor is its distribution a matter of no importance. 
Clearly every device that will promote saving on the part of 
the laboring class is to be welcomed ; and it can hardly be 
doubted that a less unequal distribution of capital, even 
though it involved some falling off in the productivity of indus- 
try as a whole, would increase the sum total of human welfare. 
The influence of insurance, so far as it widens the range of 
safe investments and thus promotes saving on the part of peo- 
ple of small resources, has a tendency to reduce the inequal- 
ities in the distribution of wealth. 

The [influence of private ownership of land in promoting 
saving is also worthy of note. I do not refer to the well 
known fact that the desire of the average man to own a piece 

1 In considering the influence of the rate of interest on accumulation some al- 
lowance ought undoubtedly to be made for the tendency of a fall in the rate of 
interest to induce larger savings on the part of those who are chiefly concerned to 
assure to themselves or their families a certain fixed income. 



413] CONCL US ION 1 3 1 

of ground stimulates his productive activity. It is the in- 
fluence of the security of the investment to which I wish to 
call attention. In spite of local fluctuations in value as popu- 
lation shifts from place to place, investments in land under 
normal conditions have always been regarded as exceptionally 
secure. A very considerable part of the savings of small 
capitalists has for this reason been placed in this form of invest- 
ment, either directly or through the medium of savings-banks 
and building and loan associations. The withdrawal of land 
from private ownership would reduce the area of safe invest- 
ments to such a degree as to cause a serious fall in the rate o 
interest in them. Whatever may be said on other grounds 
for or against private ownership of land, it cannot be ques- 
tioned that on account of the wide opportunity for safe invest- 
ment which it affords it has a great influence in promoting 
saving by persons of small means. 

From the same point of view, no greater service could be 
rendered society than that which would result from the intro- 
duction of a method of giving security to the bonds of large 
industrial corporations. Something is already accomplished 
in this direction through the custom of underwriting which 
has been growing in recent years. A large banking concern 
undertakes to float a loan for a corporation, and to give to the 
bonds the backing of its own reputation, on condition that the 
directors of the corporation agree to observe certain principles 
in the management of their property. The object of this 
stipulation is to prevent unwise action on the part of the 
directors, such as would tend to injure the earning capacity ot 
the property and impair the security of the bonds. Obviously 
such action is limited both in its range and in its efficiency. 
The invention of a system of guarantee and control which 
would give to the bonds of all established corporations the 
security which now attaches only to government bonds would 
enormously increase the opportunity for safe investment, 
would raise the rate of interest in such investments well above 



1 3 2 THE OR Y OF RISK AND INSURANCE [4 1 4 

its present level, and would thus encourage saving by those to 
whom the disutility of insecurity is very great. 

One of the greatest services which the entrepreneur renders 
society is the result of his activity in opening up new avenues 
for the employment of capital. The growth of capital is a 
characteristic feature of a progressive society, and with that 
growth comes the necessity of finding new methods of employ- 
ing it, if the rate of interest is to be kept from falling rapidly. 
The discovery of new methods of employing capital has the 
same sort of influence on the rate of interest and the incentive 
to save as the extension of the range of safe investments. Of 
the different ways in which new capital may be employed, and 
the different degrees of risk involved in them, enough has 
already been said. A few points remain to be noticed about 
the relation of the entrepreneur to this kind of risk. 

The incentive to activity by which an entrepreneur is led is 
the hope of realizing a profit. Now the origin of profit is 
always in change. It is of the nature of entrepreneurs, there- 
fore, to be continually experimenting with new methods, new 
machinery and new products. There are very unequal 
degrees of risk involved in these experiments. In some cases 
it is practically certain from the moment the new idea is con- 
ceived that the application of it will lead to the appearance of 
a large profit ; in others the outcome is a matter of a great 
deal of uncertainty. As we have already seen, there is no 
constant relation between the degree of uncertainty and the 
amount of profit. Still it is evident that of two equally uncer- 
tain experiments the one would first be tried in which the 
profit would be larger in case of success ; and that of two ex- 
periments holding out hope of equal profit, the less uncertain 
one would be first undertaken. This seems to indicate some 
sort of relationship between risk and profit. What is it, how- 
ever, that limits the action of entrepreneurs in this way ? 

So far as the experiment involves danger to existing capital, 
their choice may be due to their unwillingness to expose their 



. J - -1 CONCL USION 133 

own capital to danger, or to the difficulty of obtaining capital 
from others for such a purpose. If entrepreneurs were able 
to obtain gratuitously all the capital they wished, there would 
be no such limitation to their unwillingness to incur risk. It 
would still be true, however, that a certain profit would have 
more attraction than an uncertain one of the same size. Any 
one naturally prefers a certain gain to an uncertain one. More- 
over, an entrepreneur has to devote time and labor to the 
management of his business, and must have a reasonable as- 
surance of receiving at least as large a return from it as he 
could obtain by selling his services to others. Finally, the 
reputation for sound judgment and efficient management, 
which continued success gives, is of value to him, since it 
enables him to secure capital at a lower rate. This reputa- 
tion, however, is a part of his equipment as a laborer, and 
would increase his wages if he sold his services to others. The 
extra reward that he obtains for risking it is a part of his 
wages of management and not a part of pure profit. In our 
discussion all consideration of that part of the entrepreneur's 
income which is wages of management and which accrues to 
him as laborer and not as entrepreneur is excluded. 

As there is a limited number of entrepreneurs, there must 
be a limit to the range of their activity. As a certain gain is 
more attractive than an uncertain gain, entrepreneurs will nat- 
urally first select those experiments in which the probability ot 
success is great. To induce one of them to undertake a more 
uncertain experiment when a less uncertain one is open to 
him, the profit in the former, if it succeeds, must be greater 
than the profit in the latter. To this extent there will be a 
relation between the chance of obtaining a profit by undertak- 
ing an industrial experiment and the probable amount of the 
profit. It is evident, however, that this extra profit is not the 
reward for bearing risk. Under the conditions assumed, the 
entrepreneur is exposed to no risk of loss in either undertak- 
ing. The amount of profit to be obtained in the more hazard- 



1 34 THE OR Y OF EISK AND INSURANCE [416 

ous experiment is in no part due to the risk. It is determined 
by other conditions with which the risk has nothing to do. 
Although the entrepreneur obtains a larger profit by under- 
taking a more hazardous experiment, he does not obtain it 
because the experiment is more hazardous. If the only 
opportunity open to him were one in which the chance of suc- 
cess was slight and the profit in case of success not large, he 
would have no hesitation about undertaking the experiment, 
provided he risked no capital of his own and his wages of 
management were assured him. While, therefore, in their 
selection of industrial experiments entrepreneurs are naturally 
led to undertake first those in which there is the greatest 
reward in proportion to the uncertainty of success, and while 
in consequence there is a relation between uncertainty and 
profit in this class of undertakings, the action of the entre- 
preneur in entering upon the experiment cannot be called the 
assumption of risk, and the large profit is not to be confounded 
with the reward for risk-taking. The person who furnishes 
the capital, and stands to lose it if the experiment fails, bears 
all the risk of the undertaking. The choice of a certain profit 
rather than an uncertain one by the entrepreneur is the same 
sort of an act as the choice of a large profit rather than a small 
one. 

On account of technical limitations the activity of insurance 
companies has been for the most part confined to the assump- 
tion of risks in which the existence or the possession of prop- 
erty was involved. They have made few attempts to insure 
goods of any kind against loss of value. Many commodities 
are liable to great fluctuations in value, and in some cases these 
fluctuations have serious consequences for the welfare of soci- 
ety. Agricultural products are commodities of this kind. 
That the fluctuations of their value are great is due to imper- 
fect control of the supply by those who produce them and to 
the inelastic nature of the demand for them; that these fluctua- 
tions seriously affect the welfare of society is due partly to the 



--I CONCLUSION 135 

fact that they constitute an important part of the consumption 
of the masses of the people, and partly to the fact that the 
efficient distribution of the supply requires temporary accumu- 
lations of large stocks of the goods in the hands of manufac- 
turers and dealers. The former fact makes it difficult for 
people with small incomes to apportion their expenditures 
over a series of years to the best advantage. Excessive con- 
sumption in times of low prices is followed by too great,a con- 
traction of consumption in times of scarcity. The total utility 
of the commodities consumed is thereby diminished. The 
second fact tends to increase the price of the commodities in 
times of abundance and scarcity alike, since the great uncer- 
tainty incurred by investing capital in large stocks of the goods, 
for purposes either of manufacture or of sale, restricts the flow 
of capital into such investments to amounts which yield a large 

reward. 

It is in reducing the cost of this special kind of risk that 
speculators serve society as insurers. By a system of transfer 
of risks, which will be considered in a moment, they take upon 
themselves the chance of gain or loss through fluctuations in 
the value of certain commodities in the hands of manufacturers 
and dealers. That this is no part of the purpose of the specu- 
lators is undoubtedly true. Their immediate object is to make 
money through fluctuations of prices. We need not stop to 
consider the general phenomena of speculation nor its influ- 
ence upon society.^ We are concerned only with that part of 
the activity of speculators which serves indirectly to reduce 
the cost of uncertainty. The way in which this service is 
rendered may be made clear by a concrete illustration. 

1 See H. C. Emery, Speculation on the Stock and Produce Exchanges of the 
United States, 1896, for an account of the activities of speculators and the mechan- 
ism of stock exchanges. See also « The Place of the Speculator in the Theory of 
Distribution," by the same author, Publications of the American Economic As- 
sociation, Third Series, I, 1900, pp. 103-I14, for a discussion of the question sug- 
gested by the title of the article. The illustration of the service of the speculator, 
given in the text, is condensed from this article. 



1 36 THE OR V OF RISK AND INSURANCE [4 1 8 

A miller who buys large quantities of wheat to grind into 
flour is exposed to a chance of gain or loss through a change 
in the market price of the grain. If the price of wheat varies, 
the price of flour will probably vary with it. This uncertainty 
about the movement of prices is a disturbing factor in the 
miller's calculations. He frees himself from it by a transaction 
on the wheat market. At the same time that he buys a quan- 
tityj^of wheat for his mill, he sells the same amount to a specu- 
lator for future delivery. When he sells his flour he delivers 
the wheat. If the prices of wheat and flour have fallen, his loss 
on the flour is made good by his gain on the wheat ; and, on 
the other hand, if prices have risen, the extra gain that he 
realizes from the sale of the flour is used in settling his con- 
tract with the speculator. In either case he is left with the 
legitimate profits of his business, unaffected by any changes in 
the price of wheat.' 

It is evident that for the miller this transaction is a form of 
insurance. By means of it he purchases security from certain 
dangers to which he would otherwise be exposed. Its nature 
is somewhat concealed by the peculiar form of the premium 
which the miller pays. Instead of paying a fixed amount, he 
surrenders to the speculator the chance of gain at the same 
time that he transfers to him the chance of loss. This fact, 
however, does not alter the real character of the transaction. 
It is evident that in the long run the speculators obtain the 
advantage, as otherwise they would not continue to render the 
service. Whether on account of their better information as to 
the condition of the market, or their greater shrewdness in 
anticipating future movements of prices, their contracts are 
made on such terms as to yield them a reward. This gain is 
virtually the insurance premium. 

The benefit which society derives from this transaction is of 

1 By this transaction the miller does not wholly free himself from "speculative" 
risk. There is a possibility of an independent change in the price of flour during 
the period of grinding. This risk the miller himself still carries. 



4 1 9] CONCL USION 127 

the same kind as that which regular insurance companies 
confer. The diminution of the uncertainty to which the 
miller is exposed makes him willing to carry on his business 
on a much smaller margin than he would otherwise require. 
He no longer demands a large extra reward for carrying risk. 
How this increases the productivity of capital and causes a 
gain for the consumer of flour through a fall in its price, can 
be seen at once in the light of the principles already estab- 
lished. 

Professor Emery raises a question as to the economic char- 
acter of the service which speculators render and the category 
of distribution in which his income belongs. He finds it diffi- 
cult to discover in the insuring activity of the speculator any 
recognized productive function. Thus we read : " Speculative 
risks stand in a way outside the process of production and 
speculative gains constitute, not a coordinate share with 
wages, interest and profits, but rather such claims to the prod- 
uct as are represented in all property rights." Again we 
read : " Speculation does not directly produce wealth, but 
there is a real increase or decrease in the value of property 
due to outside causes, and this gain or loss in value is shared 
by speculators." 

Now the appropriation by speculators of gain which accrues 
to property that they themselves own does not require any 
explanation. The possibility of such chance gains is an inci- 
dent of the institution of private property. Evidently this is 
not what Professor Emery has in mind. It must be the ap- 
propriation by speculators of a part of the gain that accrues to 
the property of others that he is considering. If the owners 
of the property are willing to make over this gain to the spec- 
ulators, the reason must be that the latter are rendering some 
economic service for which the former are willing to pay. 
Otherwise the whole affair is reduced to the plane of a gam- 
bling transaction and has no place in economic theory. The 
only economic claim that any one has to a share of the social 



1 38 THEOR V OF RISK AND INSURANCE [420 

product is based on the fact that he has helped to create the 
product. That speculators, so far as they act as insurers, use 
their capital and labor in a way that increases their productivity, 
Professor Emery himself recognizes in many places. We read, 
for example, " This does not mean that the speculative market 
is not an aid to production. It is difficult to see how a great 
world trade in such staples as grain and cotton would be pos- 
sible without it." We are told more specifically that " Under 
the old method [before speculation was introduced] the trader 
had to allow a margin of five or ten cents a bushel on wheat 
to cover a possible fall in value. To-day traders will carry 
wheat on a margin of a fraction of a cent, and the allowance 
for risk is practically nothing." In view of these facts and 
many others of a similar character which Professor Emery 
cites, it is not easy to understand why he is unwilling to ac- 
knowledge the productivity of the activity of the speculator. 
If traders carry wheat on a smaller margin, it means that less 
capital is needed to perform a given amount of work. In 
other words, the capital is more productive than it was before. 
This surely justifies us in calling the activity of the speculator 
productive. Speculation, so far as it is insurance, is a phe- 
nomenon of the production of wealth. Distribution through 
this kind of speculation is a direct result of productive service.' 
Speculation, from the point of view from which we have 
been considering it, is an institution which society has created 

^ Space is lacking for a consideration of the difficulties raised by Professor 
Emery as to the economic identity of the speculator. There seems to be a con- 
fusion between personal and functional distribution in his discussion. The spec- 
ulator could not secure the miller from loss unless he possessed the requisite 
amount of capital ; he must therefore be a capitalist. A part of his income is 
interest, and this is high on account of the hazardous nature of the business. His 
occupation calls for the expenditure of much physical and mental energy ; he is 
therefore a laborer. A part of his income is wages, and this part is also high on 
account of the great degree of skill required in the business. As he is at the same 
time residual claimant, he is in the position of the entrepreneur, and is entitled to 
any profit that may appear. The speculator, therefore, combines the three func- 
tions of capitaHst, laborer and entrepreneur. 



42 1 ] CONCLUSION 1 39 

for the purpose of obtaining security against a special class of 
risks. Perhaps it would be more accurate to say that the 
institution has been created for other ends, some good and 
some bad, and has been utilized by society for this purpose. 
Insurance is something of a by-product. That other opera- 
tions of speculators, which are of very doubtful service to so- 
ciety, have to be set over against their activity as insurers can- 
not be denied. The evils of speculation are many and gross. 
It may well be hoped that in the course of time a different 
method of reducing the burden of this kind of risk may be 
evolved, which shall be as efficient as speculation and free from 
many of its attendant evils. 

The central principle of the static theory of risk, so far as it 
deals with risks to capital, may be stated in a single sentence. 
In the approximate static state, capital will be so apportioned 
under the influence of risk that the productivity and reward of 
the different units, in the absence of other disturbing influences, 
will vary directly as the risk to which, in the judgment of its 
owner, it is exposed. The economic cost of risk in such a 
society would be due to inequalities in the degree of risk in 
different investments. This would prevent the perfect static 
apportionment of capital. The loss of productivity on account 
of the uneconomic apportionment of capital is the measure of 
the cost of risk in a static society. 

As long as man's knowledge remains imperfect, accidental 
destruction of capital will be an incident of the production of 
wealth. The amount of such loss is far greater in some indus- 
tries than in others. If society wishes to enjoy the product of 
a hazardous industry, it must be willing to pay a price high 
enough to replace the capital accidentally destroyed as well as 
that used up in the process of production. Such replacement 
keeps the fund of capital intact, and so long as that is done, 
society as a whole is not concerned with the way in which 
the fortunes of individual capitalists may be affected by 
accidental causes. To the individual, however, it makes a 



140 THEORY OF RISK AND INSURANCE [422 

great difference whether he is the one who suffers the acci- 
dental loss or the one who escapes. If his capital has been 
accidentally destroyed, it is small comfort to him to know that 
the social fund of capital has been kept intact. He is, there- 
fore, reluctant to invest his capital in hazardous industries, and 
he does it only when the average net return in them is above 
the marginal return in safe investments. This extra net return 
which the investor demands on account of uncertainty is the 
reward for risk-taking. The amount of the reward will vary 
with the degree of the uncertainty. It will be fixed for each 
degree of risk by the reluctance of the marginal investor whose 
capital has to be employed under conditions where it is ex- 
posed to that risk. 

Entrepreneurs have to pay for the capital they borrow in 
proportion to the risk to which it is to be exposed. To the 
entrepreneur, therefore, reward for risk-taking is a part of the 
expense of production. He recoups himself by adding the 
extra cost to the price of the commodity he produces. In 
this way the cost of risk is finally shifted to the consumers. 
Consumers, then, as well as capitalists, have a voice in deter- 
mining whether a hazardous industry shall be carried on. 
The capitalist decides what net reward he will require on 
account of the uncertainty. The consumer then indicates 
whether his desire for the product of the industry is so intense 
that he is willing to pay a price for it which will replace the 
capital used up and accidentally destroyed and leave the cap- 
italist the reward which he demands. 

There are two ways in which society may reduce the cost 
of uncertainty. It may adopt means to prevent the occur- 
rence of accidental loss, or measures which will reduce the 
degree of uncertainty or its repellent influence without affect- 
ing the amount of positive loss. All measures of the former 
kind may be grouped under the name of prevention. The ad- 
visability of adopting any such device depends upon the rela- 
tive expense of production with it and without it. It is the 



423] CONCLUSION 141 

entrepreneur who decides, and he does it by comparing the 
interest on the cost of the preventive measure with the saving 
of interest on his present investment through the diminution 
of risk. Those measures will be adopted which in the end are 
cheaper than the uncertainty they annihilate. 

The general method of reducing uncertainty and unwilling- 
ness to bear it is through the transfer of risk. Considered as 
a transaction between individuals, this is advantageous to 
society whenever the one to whom the risk is transferred is for 
any reason less reluctant to carry it than the one from whom 
it is transferred. Its greatest benefit, however, is realized only 
when the risks of many individuals are combined in a group. 
When this is done the degree of uncertainty for the group as 
a whole is diminished. The risk of the group is less than the 
sum of the risks of the individuals. The institution through 
which this combination of risks is generally brought about is 
insurance. 

Accumulations to meet accidental losses of capital are called 
insurance funds. As the amount of loss which will occur is 
in the nature of the case more or less uncertain, the amount of 
accumulation cannot be fixed exactly at the amount of loss. 
It is fixed at the probable amount of loss, as determined by 
past experience, with an. allowance for fluctuations. This 
allowance varies with the degree of uncertainty as to the vari- 
ation of the actual loss from the average. If all producers 
carry their own risks, the sum of these extra accumulations 
due to uncertainty will be very great. When the risks of the 
individuals are transferred to an insurance company, the com- 
pany makes the accumulations for the entire group. Since 
the degree of uncertainty for the company is far less than that 
of any individual producer, the aniount of the accumulation, 
when it is made by the company, is less than the sum of the 
accumulations of the individuals. The total accumulation is 
brought nearer to the total loss, and the extra amount, which 
from the point of view of society is an undesirable expense, is 



142 ThEORY OF RISK AND INSURANCE [424 

greatly reduced. Insurance is a method of making accumula- 
tions to meet uncertain losses, and the economic benefit which 
it confers upon society is the result of the reduction in the 
amount of these accumulations and the elimination of the part 
'-■^ due to uncertainty. 

The desire to secure the gain which the combination of risks 
produces is a force which fosters the growth of insurance. 
After the institution has once been introduced, it is evident 
that in the absence of opposing influences its use will become 
universal. If primary dynamic changes were to cease, when 
time had been allowed for all friction to be overcome and for the 
static adjustment of the productive forces of society to be 
reached, all forms of risk existing in such a society would be 
found combined in one group. The number of risks in such 
a group would be so great that the allowance to be made for 
fluctuations of losses would be almost or entirely eliminated. 
The amount of positive loss would not be affected, but the 
amount of the accumulation to meet the accidental loss would 
be fixed approximately at the amount of the loss. The in- 
dividual producer, no longer feeling the necessity of protect- 
ing himself against disaster, would no longer feel any reluct- 
ance to enter an industry on account of risk. So far as the 
influence of risk was concerned, there would be that perfect 
static adjustment of capital which insures its greatest pro- 
ductivity, and the negative loss which unequal degrees of 
risk would cause in a static state would entirely disappear. 



Systematic Political Science 



BY THE 



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VOLUME V, 1895 96. 498 pp. 

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History of Proprietary Government in Pennsylvania. 

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Lthe 'ii 



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The Growth of Cities. 

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VOLUME XV, 1901. 
Civilization through Crime. By Arthur Cleveland Hall. {^Ready in July.'\ 



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